What leads directly to an economic depression?
Some may say that a depression is triggered by trends like mounting debt and a growing deficit.
Or, the catalyst can be the Federal Reserve pushing rates progressively higher.
Then again, the culprit might be stubbornly high unemployment or plunging home prices.
In truth, however, the correct answer is "none of the above." Consider this quote from the May 2002 Elliott Wave Theorist:
"Major stock market declines lead directly to depressions."
Robert Prechter's observation is based on facts and financial history. He shows that three of the biggest market declines of the past 300 years did indeed lead to economic depression: 1720-1784, 1835-1842 and 1929-1932, indicated on the chart below:
As we noted above, many people believe economic conditions lead to depressions. But as the chart makes plain, the stock market leads the economy.
Why?
EWI's Robert Prechter explains from the same issue of Theorist:
"The stock market is modern society’s most sensitive meter of social mood. An increasingly optimistic populace buys stocks and expands its productive endeavors. An increasingly pessimistic populace sells stocks and reduces its productive endeavors. Economic trends lag stock market trends because the consequences of economic decisions made at the peaks and nadirs of social mood take some time to play out."
Prechter also noted that the "Great Depression" didn't bottom until seven months after the July 1932 stock market low. And remember, the stock market decline of 1929 to 1932 had two legs down. After the first leg, the bear market rally raised investor hopes again. Then came the second and more severe leg of the decline.
Is that history relevant today?
Given the severity of the 2007-2009 decline, most market participants probably find it hard to imagine an even more severe second leg. Optimism has climbed during much of the past two years of rally.
Yet the stock market ended lower for six weeks in a row, and fell below 12,000 for the first time since early March. Is it time to "buy the dip"?
If you're pondering that question, we offer detailed analysis and compelling commentary based on the Elliott Wave Principle.