Here's Your Wake-Up Call
As China catches a cold, Wall street sneezes, and investors look warily ahead
The Chinese have a saying: "Extreme happiness begets tragedy." It's a feeling Wall Street became familiar with earlier this decade, when the late-'90s bull market turned into the meanest bear in a generation.
But it took a stomach-churning sell-off in the global markets last week, sparked by a big drop in Chinese stocks, for Americans to be reminded just how treacherous investing can be.
At its worst point, the sell-off shaved more than 750 points off the Dow Jones industrial average. And Tuesday's 416-point plunge was the index's seventh-worst single-day loss ever.
While it's too soon to tell if the sell-off is over, investors are waking up to a frightening new possibility: that both the housing market and stocks, two of the biggest sources of family wealth, could be losing value simultaneously.
If so, no one is safe—neither Wall Street investors nor Main Street homeowners.
Shakeout. Yet "investors needed this wake-up call," says James Stack, president of Stack Financial Management and editor of InvesTech Market Analyst. It has been almost four years since stock prices dropped by 10 percent, and Wall Street is in the second-longest uninterrupted bull market ever. "Corrections" of at least 10 percent happen every 18 months on average, shaking out investors who lack conviction.
"Correctionless markets encourage complacency," says Stack. "Investors become more willing to take on risk because they don't think it's possible the markets could fall."
Indeed, more and more investors have made large, risky bets on emerging-markets stocks and high-yield bonds. Last year, mutual fund investors poured more money into stock funds that bet on the developing economies of Asia, Eastern Europe, and Latin America than into high-quality domestic portfolios.
It was hard to blame them. The riskiest investments were delivering the best returns, with Chinese stocks returning over 25 percent annually during the past five years. That's more than four times the gains of U.S. blue-chip funds.
But highflying assets can nose-dive—and did last week. Investors sought shelter in U.S. treasury securities, pushing yields on 10-year treasury bonds as low as 4.49 percent.
Many market watchers believe this was a market that was looking to blow off steam, even though the U.S. economy has been resilient and inflation is under control.
Wall Street finally found its reason to sell. On Tuesday, the Shanghai stock index plunged nearly 9 percent after Beijing threatened to reform China's soaring market—where, says Jack Ablin, chief investment officer for Harris Private Bank, "all of the ingredients for a bubble are in place."
Other factors exacerbated the U.S. slide: Oil prices climbed back above $61 a barrel, government data cast doubt on the economy's staying power, and former Federal Reserve Chairman Alan Greenspan said a U.S. recession was possible this year.
Greenspan's warning means Wall Street "will be hypersensitive to economic data in the near term," says James Paulsen, chief investment strategist for Wells Capital Management.
Case in point: After losing more than 200 points at the market's opening Thursday, the Dow quickly made up most of those losses after a manufacturing report from the Institute for Supply Management showed a bigger-than-expected improvement in the nation's factory sector.
The home front. The biggest threat to stocks now could be housing. Rising mortgage default rates—particularly in the subprime market that caters to borrowers with poor credit histories—are a major concern for the consumer economy. Lenders are starting to tighten their credit standards, which could have a further negative economic impact. Acting as a counterweight, though, the flight to quality by investors pouring into government bonds has sent long-term bond yields lower. That is likely to reduce mortgage interest rates once again and give homeowners a little breathing room.
Demand for homes is also a mixed bag. While new-home sales plummeted by nearly 17 percent in January, sales of existing homes that month hit a seven-month high amid slumping prices. The housing outlook may stay murky for months, Paulsen says.
So, how to react as an investor? Prepare for a rocky road, but don't deviate much from your long-term plan, most experts advise. And brace yourself for volatility, says Sam Stovall, chief investment strategist for Standard & Poor's. Stovall says that, since 1959, market volatility has risen by 33 percent on average in the year following dramatic, single-day sell-offs of more than 2 percent, like last Tuesday's.
Financial planners suggest investing in high-quality stocks, such as shares of large, dividend-paying companies. And take the time to rethink your appetite for risk. You should have no more than roughly a quarter of your stock holdings in foreign equities, with only 15 percent of that in emerging markets, says investment adviser Ron Rogé, chairman of R.W. Rogé & Co. in Bohemia, N.Y.
For his part, Wells Capital's Paulsen remains hopeful. "If you just step back, all we've really done over the past few years is climb one wall of worry after another," he says. The market has had to deal with fears over rising oil prices, slowing economic growth and corporate profits, growing inflationary pressures, and ongoing geopolitical concerns. Yet through it all, stock prices have edged higher.
Last week's sell-off may prove to be just another wall of worry. Investors will need to climb over this one, too.
This story appears in the March 12, 2007 print edition of U.S. News & World Report.