Unpuzzling the Plunge

People routinely exaggerate the importance of the stock market. For many, the value of the stock market is taken as the main indicator of economic well-being. This is very far from true, but the market does tell us about the perceptions of the economy by many of the people who make decisions about employment and investment. And since President Donald Trump announced his tariffs, that view has not been a good one.

As of Tuesday, the S&P 500 index, a measure that includes companies with more than 80% of the market value of all publicly traded shares, was down almost 18% against its post-election peak in mid-February. It was down 12.5% compared with its level on Election Day. That is not the story that investors who were excited by Trump’s election were hoping for.

It is very clear that the fall in stock prices is a direct response to Trump’s tariffs. Over this period, every time Trump or someone in his administration made a comment indicating that Trump was going to impose high tariffs, the market dropped. Every time there was a delay, or other walk back from tariff threats, the market rallied. And the big drop occurred in the two days immediately following Trump’s “Liberation Day,” in which he announced a set of tariffs that were considerably higher than most analysts had expected.

While most people see a plunge in the market as bad news, there are some who view it as part of a grand Machiavellian plan where rich insiders will suddenly swoop in and grab up assets at an incredibly cheap price. This is hard to take seriously for two reasons. 

First, prices are far from incredibly cheap. Even with the recent decline, the ratio of stock prices to corporate earnings is still way above its long-term average. It’s not obvious anyone should imagine they are getting a great deal with stock prices at their current level. Perhaps that would be the case if the stock market were to drop another 25% or 30%, but stock is not especially cheap now.

This view would also require that Trump’s rich allies were not currently heavily invested in the stock market, so that they would be hit just like everyone else. (To take one prominent rich Trump ally, Elon Musk has been hit very hard.) Maybe some of them did offload large amounts of stock before inauguration day, but there is no evidence that they did. 

The other reason this view seems off the mark is that it ascribes an extraordinary level of strategic thinking to Trump and his advisers. There is absolutely nothing we’ve seen from Trump in the decade he has been in the political arena that would support this assessment. He routinely makes statements and plans policies that make little sense and often are not based in reality. There is no reason to think the purpose of his tariffs are anything other than what he claims: a tool to try to reduce the trade deficit and to force foreign governments and domestic businesses to run to Mar-a-Lago to beg for special relief.

The recent sell-off is clearly bad news for people who have large amounts invested in the market, but its direct impact on the economy is very limited. There is a simple, but wrong, story about the stock market, in which issuing new shares is how companies finance new investments. If this were true, then the plunge in stock prices would likely have a direct impact on investment, since it would make it more difficult to raise funds.

However, as a practical matter, companies rarely issue shares as a way to finance investment. The bulk of investment is financed by retained earnings or borrowing from banks or by issuing bonds. Large share issuance is most often associated with the original investors in a successful business looking to cash out some of their gains and diversify their assets.  

The internet bubble of the late 1990s was an exception to this general rule. There were many startups that issued shares that could raise hundreds of millions, or even billions of dollars, for companies that were not making a profit, and in some cases did not even have a plan to be able to make a profit. These companies often used the cash raised to directly finance new investment in computers, software and other items needed to run their business.

The impact of this investment could be seen in the investment data in the Commerce Department’s National Income and Product Accounts. Inflation adjusted investment in computers and other information processing equipment increased 118% from 1996 to 2000, an average annual growth rate of 21.6%. In the next two years, following the crash that began in March of 2000, this category of investment fell by more than 50%. 

There is no remotely comparable pattern of investment at present. There is money being thrown at the development of artificial intelligence, but it is nowhere near as large relative to the size of the economy as the internet-related investment in the 1990s. Furthermore, most of the spending on AI is coming from companies with deep pockets, like Alphabet, Apple and Microsoft. If these companies decide to pull back on their spending on AI, it will be because they are no longer convinced it offers large potential profits, not because a plunge in the stock market prevented them from raising capital.

The stock market likely has a more direct effect on the economy through its impact on consumption than its effect on investment. There is a long literature on the wealth effect whereby people’s consumption depends not just on their annual income, but also in part on their accumulated wealth. The effect of stock market wealth on consumption is usually estimated to be three to four cents on the dollar. That would mean that an additional trillion dollars in stock wealth would lead to another $30 billion to $40 billion in annual consumption. 

We were likely seeing this story in the internet bubble of the late 1990s as consumption grew rapidly apace with the bubble. The saving rate, which measures the percentage of disposable income that is not consumed, fell from 6.5% in 1998 to a low of 4.3% in 2000. It then rose back to 5.6% in 2002, after the bubble burst. 

This drop in the saving rate would correspond to an increase in annual consumption of roughly 2.0% of gross domestic product. That would be equivalent to $600 billion in today’s economy. When the bubble burst, people cut back consumption and gave us the recession in 2001. Contrary to the picture often drawn of this being a short and mild recession, we didn’t get back the jobs list in the downturn until February of 2005, almost four full years after the start of the recession. Until the Great Recession, this was the longest period without positive job growth since the Great Depression.

This is the bad story of a crashing stock bubble, but it doesn’t seem like we need to have the same worries today. As is the case with investment, consumption is not especially high at present. There has not been a surge at all comparable to the surge in the 1990s. 

This is odd, since the post-pandemic run-up in housing prices has a large wealth effect. Perhaps the pandemic discouraged consumption as people continued to feel uneasy even after the worst was behind us. It’s also possible that the changed demographics play a role. In the 1990s, the huge baby boom cohort were mostly in their 30s and 40s. Now they are mostly in their 60s and 70s. 

Regardless of the cause, we have not seen the same sort of surge in consumption that we did with the 1990s stock bubble, which means there is less reason to expect a big falloff in response to a stock market plunge. It’s also worth noting that the market is still very high compared to its pre-pandemic level. Stock prices are still up more than 40%, adjusting for inflation, from their levels at the start of 2020.

This means that people invested in the stock market have still gotten a very good return over this period, although that story could change if the market continues to drop. Those complaining that the tariff-driven drop in the market has ruined their retirement are ignoring the fact that they have gotten a better return in the last five years than they had any right to expect at the start of 2020.

While the dive in the stock market may not directly cause a recession, it is telling us a lot about people’s views of the economy — one that is corroborated by a number of surveys of businesses and households. For example, the University of Michigan’s Index of Consumer Sentiment for March was 28.2% below its year ago level. Its index for consumer expectations was 32.0% below its year ago level.

The Conference Board’s Consumer Confidence Index shows the same; its expectations index hit its lowest level in 12 years. 

A kindred picture emerges from surveys of businesses. A survey of CEOs about their confidence in the state of the economy one year out fell to a level lower than at trough in the pandemic. Similarly, a survey by the National Federation of Independent Businesses revealed a significant drop in its business optimism index, and that was before Trump’s “reciprocal” tariffs were announced. 

Other surveys of businesses show the same picture. There is a sharp rise in inflation expectations, a slowing in expected growth and a huge increase in uncertainty. People are very uncertain about the state of the economy and anticipate higher inflation and weak growth and/or a recession in the year ahead. And those expectations are likely to be self-fulfilling; if businesses put off or cancel investment plans, it will reduce demand in the economy in the short-term. None of that is good for the economy. 

It will also mean less productivity growth, since investment in new equipment and software fuels productivity growth. In this sense, the tariffs are not just causing short-term pain, they are likely to have a lasting effect on the economy even if Trump backs away from them in the not-too-distant future.

The sharp drop in consumer confidence will also have a noticeable effect on the economy. People who are fearful for their jobs will be less likely to buy big-ticket items like cars or refrigerators. We will almost certainly see a sharp falloff in demand for durable goods in the months ahead. 

There was a surge in durable goods purchases following the election, as many people looked to buy a car or computer before Trump’s tariffs sent prices higher. The people who bought a new car or computer in December or January will not buy another one in April and May, even if we didn’t have a huge round of increased tariffs. The fact that many purchases were pulled forward, coupled with the impact of the tariffs, virtually guarantees weaker demand for durable goods throughout the rest of 2025.   

The best way to view the stock market is that it is an important piece of evidence on where the economy is likely to go. By itself, the drop in the market we have seen to date is not the sort of thing that would give us a recession. But it does fit with much other data showing that investment is likely to fall and consumption growth will weaken. That is the story of a recession, and the stock market seems to agree with that assessment.