A new research note from Bank of Montreal looks at the economic impact of the recent plunge in stock values.

According to the research, the slide in stock values since the start of the year would reduce growth in the U.S. and Canadian economies by 0.5% in each of 2002 and 2003, should it continue. “Relative to our current outlook, which assumes higher share values, the recent plunge in equities flags the risk of slower growth,” the note says. BMO suggest, however, that this risk is lowered “by the fact that stocks appear to be undervalued today. While this does not preclude further sharp declines, it does suggest that share prices will recover some of their losses soon.”

BMO says that the current downturn ranks as one of the nastiest bear markets on record, comparable to the 1973-74 rout, though not as severe as the 1929-1933 crash.

It notes that a decline in stocks reduces economic growth in three ways: when share prices fall, household wealth declines and people spend less; lower equity prices reduce economic activity by raising the cost of capital and discouraging investment; and, falling share prices dampen economic activity by undermining confidence.

BMO estimates that the downturn in stocks since the start of the year, if sustained, would reduce U.S. real GDP growth by 0.4% points in 2002 and 0.6% in 2003.

For Canada, BMO estimates that the decline in stocks could directly subtract about 0.6% from real GDP over a two-year period. In addition, the estimated slowing in U.S. demand would restrain Canadian GDP by 0.5% over a two-year period.

Nevertheless, it says there is reason to believe that the bear market will end soon, according to research from the U.S. Federal Reserve. “The Fed’s model suggests that the U.S. stock market is about 25% undervalued today as a result of lower share prices and bond yields. This compares with a record 63% overvaluation in January 2000, just prior to the bursting of the U.S. equity bubble in March 2000. The same model applied to Canadian data suggests that Canadian equities are similarly inexpensive today.”