The stock market is feeding the current economic fear

Instead of reflecting the current economic cloudiness, the US stock market is starting to feed economic fear. Stocks have fallen for a disheartening four weeks in a row. Some on Wall Street worry that the resulting blow to confidence, not to mention 401k statements, has set off a spiral of fear that could push prices even lower, cause people and businesses to pull back and tip the economy into a new recession.

"I'm nervous that fear will lead companies to stop hiring and people to stop spending," says Jim Paulsen, chief investment strategist of Wells Capital Management, famous for his usually bullish take on the markets.

A home sales report this past week showed that more sales than usual fell apart at the last minute, which suggests plunging stocks and dismal economic news gave buyers cold feet. At least 16% of deals were canceled ahead of closings last month.

Beth Ann Bovino, senior economist at Standard & Poor's, says that another big plunge in stocks could "push us closer to the brink." The Standard & Poor's 500 stock index ended Friday at 1,123.53, down 5% for the week. The average is down 16% during the four-week losing streak. One reason for the drop is fear that another recession, if not certain, is more likely now.

The run of bad economic news started last month when the government said the economy grew much more weakly in the first half of this year than thought. Growth, at a paltry annual rate of 0.8%, was the slowest since the Great Recession ended in June 2009.

The economic weakness has made investors more likely to sell stocks at the first hint that things are getting worse. And last week, they got signs aplenty. A regional survey by the Federal Reserve said manufacturing had slowed in the mid-Atlantic states by the most in more than two years. Existing home sales fell in July for third time in four months. Another report showed that exports from Japan, the world's third-biggest economy, had slumped for the fifth straight month. Japan is still reeling from the effects of an earthquake and tsunami in March.

The housing market, which usually helps lead an economic recovery, keeps getting worse. The plunging stock market and scary economic news won't make it any better.

"What you're seeing with the economy, on the job front, it's scaring a lot of people," says Brian Fine, a loan manager at Mortgage Master in Rockville, Md. He says the housing market will languish until buyers and sellers feel more secure about the economy.

"People are really motivated by larger economic trends. It's all about if you feel confident enough to buy a home right now," he says.

The news from Europe got worse, too. Its economy has slowed considerably — even in Germany, which has been its greatest source of strength. Fear spread that European banks, already ailing because they hold bonds of countries that are struggling with debt, were having trouble getting short-term loans to pay for day-to-day activities.

Some Wall Street analysts say reports of trouble were exaggerated, but that didn't seem to matter. For investors, the prospect of banks scrambling for cash dredged up bad memories of the global credit freeze that hit in the fall of 2008, and they sold stocks.

"A negative feedback loop ... appears to be in the making," two economists at Morgan Stanley wrote Thursday in a widely cited report that itself seemed to beget more fear and selling. It warned that the US was "dangerously close" to recession.

Stock investors aren't the only ones worried. Martin Fridson, global chief credit strategist at BNP Paribas Investment Partners, notes that investors in bonds issued by the riskiest American companies are dumping them, too. These investors fear that in a recession companies might not be able to pay interest on these so-called junk bonds.

The selling has forced up the average interest rate on the bonds to 8.3%. If investors had faith in the economy, the rate would be 4.6%, Fridson says. "I'm nervous. I think there's a very material risk of falling into recession."

Investors are responding to the risk by putting their money where they feel safe. Demand for the 10 yr Treasury note was so high last week that the yield dipped below 2% for the first time in half a century. And the price of gold has set one record after another. It topped $1,800 an ounce last week.

Although unemployment remains stubbornly high, at 9.1%, there are signs that the economy, while not strong, is still growing. Retail sales grew in July at the fastest pace since March. Employers added 117,000 jobs last month, but far better than the hundreds of thousands of jobs lost each month during the Great Recession. Factory production rose in July because automakers made more cars.

And Wall Street analysts who analyze companies and advise investors when to buy and sell don't seem to be worried. As stocks were falling Friday, research firm FactSet released figures that showed just how much more optimistic these analysts are than the average investor.

Stocks are priced at roughly 11 times their expected earnings per share over the next year. That's a steep discount compared with the market's long-term average of 15 times. Translation: If you believe the US will avoid recession and companies will generate profits as high as the analysts think they will, the S&P should be trading at 1,560 — just below the S&P's record high of 1,565 in October 2007.

Of course, if the economy is weak and earnings don't come in as expected, it could turn out that stocks were trading today at 15 times the next year's earnings. That's what many of today's sellers seem be expecting.

And skeptics note that analysts are notoriously bullish, and tend to overestimate profits as the economy slows. Wells Capital's Paulsen thinks stocks should be trading higher, though he suggests investors will pay a steep price if he's wrong.

"If we have a recession, we'll probably break 1,000" on the S&P index, he says.

Investors will be on edge this week as they scrutinize new data on the economy. On Tuesday, new home sales for July are released, followed on Thursday by a weekly report on how many people are joining the unemployment line. On Friday, the government will give its second estimate of how fast the economy grew from April through June.

The most anticipated event, though, is a speech the same day by Federal Reserve Chairman Ben Bernanke at a retreat in Jackson Hole, Wyoming sponsored by the Federal Reserve Bank of Kansas City. The Fed pledged earlier this month to keep interest rates low through mid-2013. Investors hope Bernanke will announce, or at least preview, further steps to help the economy. But economists say it is unlikely Bernanke will unveil anything ambitious.

With all the high emotion surrounding stocks, economist Joel Naroff cautions investors not to read too much into the recent swings. He says that stocks have a habit of running from one extreme to the other, including this spring, when he thought they were far too high. He thinks stocks may be fairly valued now.

They reflect an "economy that is growing but not growing at any great pace," he says. "It is not in recession."