[Viewpoint] The Significance of the U.S. Stock Market Entering a Bear Market

A stock market index decline of more than 20% is said to indicate entry into a bear market. Major stock indices, including the U.S. benchmark S&P 500, have fallen more than 20%, with the S&P 500 dropping as much as 30% from its peak. Once stock prices fall and the economy enters a contraction phase, the decline in stock prices can deepen further.

Looking at the relationship between stock prices and the economy since 1965, there have been cases where stock market peaks coincided with economic peaks, but usually stock prices led the economy by 2 to 11 months. After the economic peak, stock prices on average fell an additional 23% over 11 months. The key question is whether stock prices have already peaked, whether the economy will soon reach its peak, and whether the U.S. economy will enter a contraction phase.

The National Bureau of Economic Research (NBER) announces the official business cycle dates for the U.S. economy, specifically the months when economic troughs or peaks occur. However, since multiple economic indicators must be considered to determine whether a peak has occurred, the announcement is on average about 8 months later than the actual month of the peak. Financial markets need to predict and respond in advance. The weekly initial jobless claims are currently the fastest and most representative economic indicator to assess the current state of the economy. Currently hovering around 210,000 claims, near historic lows, there is a high possibility of a sharp increase soon. If the economy worsens or is expected to worsen, U.S. companies will reduce employment.

A decline in employment inevitably leads to reduced household income and consumption. Estimating the U.S. consumption function shows that when disposable income decreases by 1%, consumption falls by 0.86%. This time, the effect is likely to be greater. Due to the COVID-19 pandemic, service consumption?which accounts for 69% of U.S. consumer spending?is expected to contract sharply. Last year, U.S. household consumption expenditures consisted of 9% durable goods, 20% nondurable goods, and 69% services. In South Korea, these figures were 10%, 31%, and 59%, respectively. The share of service consumption in the U.S. is 10 percentage points higher than in South Korea.

Stock price declines also reduce consumption. In the consumption function estimation, a 1% drop in the stock index (S&P 500) led to a 0.01% decrease in consumption. With stock prices falling about 30%, consumption is estimated to decrease by 0.3%. Since stocks account for about 46% of U.S. household financial assets, the impact of stock price declines on consumption could be greater. Housing prices are also likely to enter a downward trend soon. This will also be a factor reducing consumption through the wealth effect. Consumption accounts for 70% of U.S. gross domestic product (GDP). As consumption decreases, the U.S. economy is likely to enter a contraction phase as early as the second quarter.

To prevent a sharp stock market decline and economic contraction, U.S. policymakers will implement more aggressive fiscal and monetary policies. However, their effect will not be greater than during the 2008 financial crisis. Federal government debt, which was 63% of GDP in 2007, surged to 105% last year, limiting the government's fiscal spending capacity. The Democratic Party, which controls the House of Representatives, is also likely to restrain government debt increases. Monetary policy also has its limits. Around the 2008 crisis, the federal funds rate was cut from 5.25% to 0%, and quantitative easing created over $3 trillion. The Federal Reserve (Fed) held two emergency Federal Open Market Committee (FOMC) meetings in March, cutting rates by 1.5 percentage points to 0.00?0.25%, the lowest possible range. While another round of quantitative easing will be implemented, since households and businesses are in the process of reducing debt relative to income, monetary policy's impact on consumption and investment will be limited.

Even in a bear market, stock prices temporarily rise. Especially if the spread of the coronavirus slows down in May, a short-term sharp rise in stock prices may occur. However, considering the relationship between the economy and stock prices, this is likely a temporary rally. It will be necessary to closely monitor upcoming economic indicators, especially those related to consumption, and respond accordingly.

Kim Young-ik, Adjunct Professor, Graduate School of Economics, Sogang University

This content was produced with the assistance of AI translation services.