Downside Risk to the Stock Market and Consumption

Summary

We investigate downside risk to the stock market and, in turn, downside risk to consumption via the equity wealth effect. The AI boom has seen stock market valuations rise sharply, led by the so-called Magnificent 7, raising concerns of a stock market “bubble.” We analyze potential factors contributing to downside risk to the stock market if investor sentiment turns decidedly more negative, thereby driving down equity prices. Downside risk to the stock market in turn poses downside risk to consumption spending via the equity wealth effect. We measure the equity wealth effect using data on household wealth, equity exposure, and how strongly households adjust spending in response to an extra dollar of stock market wealth. We then apply this framework to scenarios in which the S&P 500 falls by 25, 35, and 50 percent. We project substantive declines in US real aggregate consumption in response to the hypothetical market declines, which have important business-cycle implications.

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