Stock Market Meltdown: What You Need to Know
Wall Street might be in a panic, but here's how you can keep calm and maybe even profit
The dominoes keep falling on Wall Street. This morning, the stock market continued to lose its footing, as the Dow Jones industrial average tumbled nearly 200 points in early-morning trading before recovering some of those losses by midday. This unnerving volatility comes a day after the Dow plunged more than 387 points amid continuing troubles in housing.
What's so frightening about this sell-off is that "it's impossible to tell where you are," said Howard Silverblatt, senior analyst with Standard & Poor's. "We could be right at the bottom just before things head up, or we could be in a free fall."
But investors need to take a deep breath. While the recent sell-off in the market has led to a nearly 900-point drop in the Dow in less than a month, the stock market has yet to experience a so-called correction, which is defined as a 10 percent drop in value. So far, the Dow has lost only around 6 percent—and is still up about 6 percent for the year.
Moreover, despite the concerns over exposure to subprime-related debt, most corporations are in decent condition. "The U.S. corporate sector remains in very good shape," said Markus Schomer, global economic strategist for AIG Investments. He notes, for instance, that corporate balance sheets are in excellent health, profit margins are near 40-year highs, and cash flows remain strong.
Still, here are several things to watch for in the current market sell-off:
Look for the globalization of the subprime sell-off. The one thing that the United States is still good at exporting is its financial products. And it appears that the mess in the U.S. credit market is now spilling over into the global financial markets. Earlier this week, three hedge funds run by BNP Paribas, based in France, announced that they could not allow investors to cash out because of difficulties in valuing subprime mortgage-backed securities. This spooked the global stock markets, which have been falling in lock step with U.S. equities. Bill Knapp, investment strategist for MainStay Investments, says investors should "look for more of these headlines as other holders of these securities acknowledge pricing difficulty and sort through investor requests for asset redemption."
Expect volatility to continue to rise as investors reassess their appetite for risk. Since the bear market ended in October 2002, investors have been spoiled by an unusually long period of relative calm in the markets. But it now appears that volatility will persist, as the Chicago Board Options Exchange volatility index, or VIX, shot up to a reading of nearly 29 on Friday, which is about twice as high as it was at the start of July.
Look for increasing pressure on the Federal Reserve Board to take action. Though the Fed has not lowered short-term interest rates to stave off a credit crunch—as some investors want—the central bank has acted in other ways. This week, for instance, the Fed injected about $35 billion in liquidity by making temporary funds available to help financial institutions meet their reserve requirements. The central bank took similar action in the days following the 9/11 terrorist attacks in 2001. Still, Wall Street is increasingly clamoring for the Fed to move quickly to cut rates, which the bond market now thinks could happen as soon as September.
Be wary of financial stocks. It seems that every day, another financial institution is announcing its exposure to subprime-related debt. And they're getting punished for their risk-taking. Bear Stearns, for instance, which recently announced troubles at three of its hedge funds due to this mortgage mess, has seen its stock lose more than a quarter of its value in less than three months. Not surprisingly, the financial services sector has been among the hardest hit since the stock market began to quiver in mid July. Financial stocks in the S&P 500 have fallen 7.4 percent since July 19 and are down 9.4 percent since the start of the year.
Expect a traditional flight to safety. In times of financial turmoil—such as the bursting of the tech bubble in 2000 or the Asian currency crisis in 1997—investors often sell the riskiest assets in their portfolios and head for the safest. And the safe haven of choice for global investors is still U.S. treasury bonds, which are backed by the full faith and credit of Uncle Sam. Not surprisingly, the flood of investments into U.S. treasuries has pushed the yield on 10-year notes down from 5.25 percent in mid June to 4.78 percent today.
Expect a corresponding flight to quality. For equity investors, this means a growing demand for two things: high-quality, industry-leading companies and dividend-paying firms. For example, since the market began to slide on July 19, stocks that received an A grade by S&P—based on the quality of their earnings and other fundamental factors—have fallen 5.9 percent on average. By comparison, stocks graded B have lost 9 percent. And the C stocks are down 12.8 percent. As for dividend-paying stocks, the situation is the same. Those stocks that pay out a dividend have lost only 0.6 percent on average since the start of August, versus a drop of 2.8 percent for stocks that don't pay out any dividend income.