What's Behind the Stock Market Plunge
Q: What caused Tuesday's stock market plunge?
A: Many investors are blaming yesterday's sell-off on China's market meltdown. On Tuesday, the Shanghai stock index lost nearly 9 percent of its value, as the government hinted that it wanted to find ways to curtail the huge amount of speculation in its stock market. This explains why some are referring to yesterday's stock slide as the "China Syndrome" or "the Shanghai Surprise."
But China was only one of many drivers that pushed stocks lower.
After weeks of stabilizing, oil prices are again marching higher. Yesterday, crude oil prices climbed back above $61 a barrel. Meanwhile, the Commerce Department reported that new orders for durable goods fell a surprising 7.8 percent in January–signaling that the economy many not be as resilient as some think. This seemed to support fears that former Federal Reserve Chairman Alan Greenspan raised this week, when he hinted that the U.S. economy could still slip into recession sometime this year.
Finally, adding to the selling was another round of geopolitical uncertainty, as reports emerged that Vice President Dick Cheney may have been the target of an unsuccessful suicide bombing attack this week during his trip to Afghanistan.
How bad was the sell-off?
When you measure it based on points, it was terrible. The Dow Jones industrial average fell 416.02 points, marking the biggest one-day decline since Sept. 17, 2001. It was also the seventh-worst single-day performance for the Dow ever.
But you have to remember that the Dow is starting off from a much higher base–in fact, it was trading near record highs before the slide. So while 416 points sounds terrible, it wasn't that bad when measured in percentage terms. On that basis, the Dow fell 3.3 percent Tuesday, which was the worst performance since the days leading up to the war in Iraq in March 2003. And on percentage terms, this didn't even crack the top 250 worst trading days in history.
How did the market react this morning?
While Asian stocks generally slumped in reaction to yesterday's news, the good news was that stocks rebounded in mainland China today–and they appear to be rebounding slightly in the U.S. as well. The Dow Jones industrial average jumped more than 60 points at the open, as some bargain hunters came into the picture. Then, the benchmark index fell back to about even. But by around 10:45 a.m. EST, the Dow was back up more than 100 points.
Was there a silver lining to the market's decline?
Yes. The sell-off offers some investors a buying opportunity to get back into the market. After all, stock prices are 3 percent cheaper than they were a day ago. Investors must also keep in mind that stock prices aren't supposed to go straight up. In fact, bull market rallies are usually peppered with minor sell-offs and corrections that give investors time to rest–and re-enter the market at attractive prices.
In this way, market slides can be thought of as earthquakes. While no one wants to live through a quake, it's always better to experience a minor tremor rather than the big one. And just as small tremors alleviate pressure making large quakes less likely, modest sell-offs often embolden the bulls in a bull market.
Is this the start of a so-called correction?Not yet, but it's certainly possible. Technically, a market correction is defined as a 10 percent decline in stock prices. Yet yesterday's sell-off only shaved about 3 percent off the market's value. The truth is, the U.S. stock market hasn't seen a real correction since the bear market ended in October 2002–which means eventually we're due for one.
Is this the start of another bear market?
It's way too soon to be thinking bear market. Bear markets are officially defined as a sustained 20 percent drop in equity prices. And we're nowhere near that. To be sure, "today's market action has no doubt left many asking, 'Is this the beginning of the end?' says Tim Swanson, chief investment officer for the National City Private Client Group. "The short answer is we don't think so," he says.
So what's the significance of yesterday's market slide?
It serves as "an important reminder that volatility won't stay low forever," Swanson says. "After a very long period of low volatility, it is easy to get lulled into a false sense of security. Investors need to remember that in order to earn attractive rates of return, you must be willing to accept risk." And the downside of risk is the probability of actually losing some money in the stock market.
Why did investors in the United States get spooked about a drop in China's stock market?
Joseph Quinlan, chief market strategist of global wealth and investment management at Bank of America, points out that "China's market downturn comes at a time when U.S. investors have never been more exposed to the emerging markets." He's right. Last year, fund investors did something remarkable: They shoveled more new money into high-risk emerging-markets stock funds–which invest in the emerging economies of Asia (including China), eastern Europe, and Latin America–than they invested in U.S. stock funds, according to Citigroup Investment Research. That's probably because investors love to chase past performance.
China was particularly popular, as U.S. investments in Chinese stocks rose to $5.2 billion, up from $4.9 billion in 2005. "That represents a sea change from prior years," Quinlan says.
Is China in danger of bursting like the late '90s Internet bubble?
Many market strategists don't think so. The reason the Chinese stock market sold off was that government authorities indicated that they would be strengthening securities enforcement and adopting new rules to reduce rampant speculation. While that spooked the markets in the short term, in the long term it could be a positive development.
Regardless of the market reaction, S&P forecasts that China's economy will still expand by about 9.5 percent to 9.9 percent in 2007–which is about three times the growth rate for the U.S. economy.
Bob Doll, global chief investment officer of equities at BlackRock, notes that "the market downturn in China is primarily a local event, and we do not expect that this decline will have a widespread, long-term impact across the globe."
Does this mean investors should no longer consider putting money in the foreign markets?
Absolutely not. The foreign markets represent more than half of the world's market capitalization, so there's still a great deal of opportunity overseas. But the recent slide should serve as a warning for investors to be careful when it comes to investing in the emerging markets overseas.
Unfortunately, the euphoria surrounding the emerging markets is starting to resemble the craze surrounding tech stocks in 1999. For example, according to a study by Hewitt Associates last year, the average 401(k) savers who invested in emerging-markets stock funds last year held more than 16 percent of their money in that risky asset class. And a third of those 401(k) participants held more than 20 percent of their retirement savings in the emerging markets. To put this in context, financial planners suggest that investors should probably keep no more than 5 percent of their money in this risky asset class.
Is there a way to remain fully invested but play some defense?
Yes. The market sell-off drove investors into a classic "flight to quality." So defensive-minded investors may want to stick with high-quality dividend-paying stocks, since the dividend income will serve to stabilize those holdings. Beyond that, market strategists suggest focusing on large-capitalization stocks over shares of small companies. And within the category of large-cap stocks, stick with companies with strong and consistent earnings growth.