How the stock-market drop could drag down the U.S. economy

The U.S. economy is growing at the fastest rate in three years, unemployment is at record lows and consumers are feeling confident. So why are stock markets cratering?

It's not unusual for markets to move in a different direction from other economic indicators, like business hiring or GDP. But for some on Wall Street, the third-quarter GDP report released on Friday was the latest in a string of mixed signals that show the economic expansion has peaked and could start slowing as early as next year. The majority of stocks in the S&P 500 are down 10 percent or more from their recent highs. Even allowing that the stock market doesn't predict the future, prolonged see-sawing of share prices could have a negative effect on consumers and businesses, dragging down growth that way.

Here's why that matters. GDP fundamentally reflects events that have already happened in the economy: Goods that have been purchased and investments that have been made. Financial markets, on the other hand, are forward-looking: They point to where investors think the economy is going.

"In a nutshell, stock markets are constantly looking to the future, whereas GDP is stuck in the past or the present. This naturally leads to a schism in their respective growth rates," financial analyst Surashree Sahasrabudhe wrote in a recent blog post.

While the stock market is not the economy, the market does sometimes respond to the same signals that drive overall economic growth. For many on Wall Street, this month's stock drop -- the biggest monthly decline so far in eight years -- reflects the fact that financial conditions have become more challenging, particularly with interest rates rising.

Companies that have a hard time getting affordable financing are likely to invest less, which crimps their ability to make more profits—hence, a falling stock price—and has real effects on other economic activity, including hiring.

"If corporations find it difficult to finance new investment, that itself creates a drag on the economy," said Ing-Haw Cheng, a professor of markets at Dartmouth's Tuck School of Business. "Firms might have wonderful ideas, but if investors are staying home and not financing these ideas, you could create a drag on investment."

To bolster that example, the latest figures from the Commerce Department show that business investment, a key component of GDP, grew at a very low rate in the last quarter, while shipments and orders both stalled.

"[H]igher interest rates are already restraining spending," Capital Economics wrote in an unusually pessimistic outlook that declared, "it's all downhill from here."

If that weren't enough, there's evidence that a sharp stock-market fall can spook investors and consumers, leading to real economic effects.

"[C]hanges in stock prices can have an adverse effect on spending, at least in the short-term," Joseph LaVorgna, chief economist for the Americas at Natixis, said in a note. "[I]f the recent market swoon persists, consumer spending could slow over the next few months with negative effects on retail sales and GDP growth."

It's the opposite of the "wealth effect," where a rip-roaring stock market can make workers and consumers feel wealthier, inspiring them to spend more and thus boosting economic growth.

In one sense, it doesn't matter why stocks fell—but if they don't rise, or at least stabilize, then it could presage a real and longer downturn in the U.S.' economic expansion, according to a recent Goldman Sachs analysis. "[T]he stock market is likely to turn from a significant contributor to strong growth at the start of the year into a modest drag next year, barring a further rebound in equity prices," analyst Daan Struyven predicted.

It's worth noting the stock market has seen much worse. The market is more volatile today than it was last year—but last year, and the four years prior, were also unusually calm.

"There's probably a little bit more uncertainty that is causing investors to whipsaw back and forth, but in a historical context it's not earth-shattering either," said Dartmouth's Cheng. "We're just not used to it, but it's a good reminder that the stock market is risky."