The Key Factor That Leads Directly to an Economic Depression

What leads directly to an economic depression?

Some argue that trends like mounting debt and an ever-widening deficit will trigger a depression.

Others say it can happen if the Federal Reserve aggressively raises rates.

Then again, the culprit might be chronically 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. Three of the biggest market declines of the past 300 years did indeed precipitate economic depressions: 1720-1784, 1835-1842 and 1929-1932.

In the same issue of the Theorist, Prechter explains why the stock market leads the economy.

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 major 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 find it hard to imagine an even more severe second leg -- if anything, they expect the opposite. Even after a nearly 4-year market rally, the headline below represents an amazingly pervasive bullish sentiment.

This Could Be a Huge Bull Market

CNBC, Jan. 31

Note that there's widespread elevated optimism despite an economy that remains persistently weak.

Consider the positive spin on the negative Q4 gross domestic product number (-0.1%).

People will be stunned to see that today's GDP report went negative for Q4 ... the first negative print since The Great Recession.

But the report isn't that bad. In fact it was arguably good.

Business Insider, Jan. 30

Headlines about the latest GDP report include phrases such as "glass half full," and "not that bad."

But no matter how you slice it, a negative GDP number is a negative GDP number.

You can almost be sure that if the stock market was trending downward, the spin would be negative. After all, the economy is struggling. And if that's the case after the market has been trending upward, imagine the economic scenario if the market turns down.