Stock market dives: leading economic indicator, or recurring false alarm?

By Daryl G. Jones, contributor

FORTUNE -- From its peak in late April to the close last Friday, the S&P 500 has declined just over 12%. That is a correction of real historical magnitude. Stock markets around the globe have mirrored this move, if not exceeded it. Pundits have justified the correction primarily on the sovereign debt issues in Europe. But the question for stock market operators is, as always, what's next?

Many are saying this correction is the buying opportunity of a lifetime. In fact, late last week, Laurence Fink, the CEO of the world's largest asset management firm BlackRock (BLK, Fortune 500), stated that: "We are ready to rock and roll as a country." The takeaway being that fundamentals are set to improve in the United States and the recent stock market correction is just that, a correction.

Fink's underlying view has to be that markets are not leading indicators for fundamentals. But history, in contrast to Fink, paints a different story of the stock market's ability to predict the future.

Before diving into that, it's worth figuring out how often corrections of the current magnitude occur.

The table at the bottom of the page, is drawn from an analysis published by Capital Research and Management Company, which provides an overview of types of equity declines, their frequency, length and so on. While this particular data is based on the Dow Jones Industrial Average, which is an index with a smaller number of stocks than most broad indices, it still serves as a decent proxy for general market corrections in the United States.

A famous if apocryphal quote related to the fortune-telling ability of stock markets is that stocks have predicted 10 out of the last 3 recessions. Translation: The stock market often corrects, but that does not always mean the economy is moving down with it.

While history suggests that stock market corrections have a mixed ability at predicting recessions, the stock market as leading indicator for economic activity is actually based on a number of fundamental underpinnings:

1. The wealth effect

As the stock market declines, investors feel and indeed are less wealthy, so they spend less. With consumer spending estimated to be close to two-thirds of GDP, a material decline in the wealth of consumers, as reflected in their equity portfolios, will clearly have an impact on their ability to spend. Though roughly only 50% of households own stocks, wealthier households (many of whom do own equity portfolios) contribute a disproportionate amount of spending. As their wealth is diminished, so too is the associated spending ability of the consumer.

2. IPO and equity financing slowdowns

A declining or tumultuous stock market also inhibits equity financing. The best and most recent example of this was 2008, a year in which the stock markets in the U.S. were down over 30%. According to a study by Renaissance Capital, there were only 43 U.S. IPOs in 2008 that raised over $50 million. This was down from 272 in 2007 and was the slowest year for IPOs since 1979. The IPO market is obviously a proxy for broader access to capital. With more limited access to capital, companies will generally grow at a slower pace, which will eventually be reflected in the growth rate of the economy as a whole.

3. Pension plans plunge

Actually, not just pensions, but many types of organizations plan their spending around the performance of their portfolios. University endowments are the largest other example. Since there is typically some spending component associated to the performance of their portfolios, a decline will lead to less spending in the future by endowments and pensions. A good example of this would be my own alma mater, Yale University, which had to institute budget cuts partially due to the decline in value of its endowment in 2008. (Despite the 2008 decline, the Yale Endowment's track record remains outstanding.)

4. Confidence

Finally, stock market performance is directly related to broad confidence in the economy, and in America. The performance of the stock market, rightly or wrongly, is oft referenced as a bellweather of how specific economic policies are perceived, whether they're effective, and whether the economy is in good overall shape.

As a result, we are ingrained with the idea that "stock market up" is positive for the economy, and "stock market down" is negative for the economy, which impacts broader confidence. As broader confidence shifts in correlation with the market, it will impact the willingness of both consumers and companies to spend and invest to expand, and therefore impact future economic growth.

Logically, the sharper the decline in the equity markets, the more likely future economic growth slows dramatically, and a double dip recession scenario becomes more and more possible. Setting aside the short-term economic pain of a double dip, the one, maybe only, good thing about negative GDP numbers for market players is that they are typically a leading indicator as well -- of coming stock market outperformance.

--Daryl G. Jones is the Managing Director of Risk Management at Hedgeye, a research firm based in New Haven, Conn. To top of page

Type of decline Average frequency Average length Last occurrence Last pre-March 2009 occurrence
-5% or more About 3x a year 48 days Mar-09 Mar-08
-10% or more About once a year 115 days Mar-09 Mar-08
-15% or more About once every 2 years 217 days Mar-09 Mar-08
-20% or more About once every 3.5 years 338 days Mar-09 Oct-08
Source: Capital Research and Management