Weak stock market may be hurting weak economy, report suggests

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Is the stock market a mirror that simply reflects what’s going on in the underlying economy? Or is it a force unto itself, actually pushing the economy up or down?

That question -- whether there’s a ‘wealth effect’ or, in today’s troubled economy, a ‘reverse wealth effect’ -- has been debated a lot over the years. But it’s getting renewed attention lately as investors, corporate managers and just about everybody else try to make sense of the stubbornly weak economy.

The basic question is whether the dramatic gyrations in the stock market -- and to lesser degrees, in the fixed-income and commodities markets -- affect consumer and business spending.

A new report from Merrill Lynch suggests the answer may be yes -- that the stock market is weighing on the economy because its acute fluctuations are so psychologically unsettling.

‘Market expectations can be self-fulfilling in the short-run; the equity market can create its own reality,’ economists Neil Duta and Ethan Harris write in their report ‘The chicken or the egg?’

‘In an environment of high uncertainty, the economy is more vulnerable to financial shocks,’ they wrote. ‘A sharp negative shift in investor sentiment can feed on itself, reducing economic activity. This is the big risk for the economy today.’

Merrill points to the stock market’s deep selloff last month after the U.S. government’s credit rating downgrade by Standard & Poor’s. The economy was weak but wasn’t demonstrably worsening. But the selloff was so severe that it raised worries that the economy was sinking quickly.

The report quotes two prominent experts bemoaning the negative effect of the market.

“On days without much news, the market is simply reacting to itself,’ said Robert Shiller, a Yale University economics professor. ‘And because anxiety is running high, investors make quick, sometimes impulsive, responses to relatively minor events.�

And this from famed hedge-fund manager George Soros:

‘If a double-dip recession was in doubt a few weeks ago, it is less in doubt now because financial markets have a very safe way of predicting the future: They cause it.’

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-- Walter Hamilton