14

Why do stocks drop during a recession?

Where does the money go in favor of these assets?

Or is the first question not true?

  • 1
    by "stocks necessarily drop", do you mean "the overall market always drops" or "every individual stock drops"? Because there are companies whose stock improves in a recession. – Acccumulation Mar 1 at 15:44
  • @Acccumulation the overall market – user1 Mar 1 at 15:45
36

During a recession, economic growth slows. This can lead to higher unemployment which in turn results in lower consumer and company spending which in turn leads to decreased company revenue and profit, lowering the fundamental value of stocks.

Lower investor confidence contributes to market decline as investors move to safer assets (defensive stocks, bonds, certificates of deposit, money market accounts). Some people, particularly the newly unemployed, pull money out of the market just to meet basic needs.

  • 11
    @Maxed : Apologies for the native English speakers who don't understand the issues with abbreviations and localized jargon. CD in this context is a Certificate of Deposit. "Money Market" has more than one meaning, but I suspect he's referring to a type of bank account with a higher interest rate but restrictions on the number withdrawals per month. (I have no idea if this is a uniquely American thing) – Joe Feb 28 at 15:39
  • 3
    Also Precious Metals, Property ... – Daniel Feb 28 at 16:48
  • @Bob Baerker Do you really see money going into bonds nowadays? There is no return on IG bonds and high yields would also take a hit during a recession. – user1 Mar 1 at 8:33
  • @Maxed - Do you have any idea how many bonds are out there? There are 100's of bond ETFs,, each with billions of dollars of bond assets.. Today, March 1st, there are over a billion dollars of municipal bonds being issued. All major brokers have bond desks. Yes, I really see money going into bonds nowadays. – Bob Baerker Mar 1 at 11:44
  • @Bob Baerker I ment in favor of stocks given a recession. But maybe thats what you answered? I have the impression that they are not much safer then stocks(which also might not be true) nowadays, atleast not those giving any return. – user1 Mar 1 at 12:11
9

As for "where does the money go", the fact that a stock price goes down doesn't mean money is going anywhere.

E.g. if a stock is first priced at $100, but then some shares are traded between investors at a price $90, then that is the new value of the stock. But only some shares now have a new owner, and no money left.

  • I was referring to alternative investments which will give better return which investors trends to switch to in such a situation. Bonds are kind of off limits I guess since bonds with reasonable risk give no returns nowadays. And in a recession the highrisk bonds tend to take hits aswell. – user1 Mar 1 at 8:28
  • @Maxed Consider editing your question to clarify it with the info from your comment. – studog Mar 1 at 15:42
  • @RemcoGerlich is correct... 'money' gets erased when stocks go down. As far as alternatives go, this is the conundrum we all face. Since all asset classes lost value in 2018, investors are desperate to find return anywhere. This leads to bubbles as retail investors crowd into any asset class that appears to have momentum. Bitcoin and TLRY being recent examples. – Keith Knauber Mar 1 at 23:57
  • @Keith Knauber - Money doesn't get 'erased' when stocks go down. Share price gets 'erased', aka the new trading value'. The money is still there (the stock market doesn't create money). It has just changed hands. – Bob Baerker Mar 4 at 2:15
  • @BobBaerker I stand corrected. There is no direct relationship between stock prices and the real money supply. There is a correlation between overall stock market capitalization and the 'money multiplier' effect, and that relationship is complex. The relationship between the stock market and the 'money multiplier' is important to understanding the environment we are in today. alt-m.org/2016/07/21/why-the-money-multiplier-remains-so-low – Keith Knauber Mar 5 at 21:42
5

The stock market is a market.

When there's a lot of money in a market, and everyone is competing to buy a limited number of stock shares, demand is high and prices tend to go up.

However in a recession there is job loss so people have less to spend, people with jobs are catching up their emergency funds instead of investing, people are competing to sell the shares they have to fund life needs, and there are fewer buyers to meet the supply. That tends to drive prices down.

  • 3
    Most of the people living hand to mouth don't participate much in the stock market in the first place. They don't sell shares because they don't own any. – Barmar Feb 28 at 20:36
  • 1
    @Barmar It works the same in any income class that does own stocks. High-income tech workers get smaller bonuses, company owners get less profit, they all have less money to invest in stocks and may need to sell stocks to get money to spend elsewhere. – jpa Mar 1 at 15:01
  • @Barmar "people living hand to mouth" is a category that grows and shrinks. In a recession, it grows. – Harper - Reinstate Monica Mar 1 at 15:57
  • 84% of stocks are owned by the wealthiest 10% of Americans. I doubt any of them had to sell stocks to make ends meet. The bottom 80% of Americans only own 6.7% of stocks, and when you get down to the bottom 50%, who would have needed sources of cash, stock ownership is probably negligible. – Barmar Mar 1 at 19:41
  • Only about 54% of Americans own any stocks at all, and almost all of them will be in the upper income brackets. – Barmar Mar 1 at 19:42
3

One way to value a stock is the present value of all future dividends. If the slowing economy is going to reduce dividends, or increase the probability of the reduction of dividends, this will reduce the value of the stock by definition.

  • Many companies do not pay any dividends at all, and many others pay dividends so small that it'd take decades or longer to pay for the value of the share. Example: Activision stock price is currently around $42. It pays annual dividends. The dividend for 2019 is set so be $0.37 per stock. It would take over a hundred years for you to actually make a profit that way (assuming the dividend wouldn't change). The value of a stock thus often has little to do with the value of its dividends, as the main source of profit lies in selling it rather than in collecting dividends. – Gweddry Mar 1 at 11:10
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    @Gweddry I think you're mixing up a lot of concepts. The specific quesiton is about how to value a stock, not how to make money off of stocks. The value of a stock is essentially tied to its future performance, which classically is the greater of its dividend yield or its liquidation value. About "taking over 100 years for you to actually make a profit" -- that $0.37 is profit. That is your share of profits as part owner of Activision -- which you paid $42 for the rights to. – Chuu Mar 1 at 14:41
  • companies like ATVI also have stock buyback programs, whereby shares are extinguished, boosting the value of the remaining shares. – Keith Knauber Mar 1 at 23:28
  • The source of the 37 cent dividend is corporate earnings. When distributed to shareholders, it devalues the company. On the shareholder side (your brokerage account), on the ex-div date share price is reduced by the amount of the dividend and therefore it is not a profit. Even worse is that if non sheltered, you pay taxes for the privilege of receiving some of your cost basis back. Dividends do not produce Total Return. That only comes from share price appreciation. – Bob Baerker Mar 6 at 17:20
0

One reason I haven't seen mentioned is that if an individual loses their job, they might need to sell some stocks they hold to make ends meet. That will add to the number of sellers or the supply of stocks lowering prices.

To sum up, the following are all reasons why stock prices will fall:

  • Distressed sellers
  • Lower expectation of corporate profits
  • Flight to quality
  • People have less money to invest

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