An Unnerving Market Drop

There's a proverb -- a curse, actually -- that goes, "May you live in interesting times." Although it's often attributed to the Chinese, its origins remain mysterious. And so it was with the stock market on February 27. In a day that was way too "interesting" for most investors, stocks plummeted -- nearly across the board and the whole session long -- in a freefall that was attributed to overnight losses in the Chinese stock market, but whose origins may be more complex.

There's no doubt that the U.S. market’s losses were unnerving, just a week after investors celebrated record highs. The Dow Jones industrial average fell 416 points, or 3.3 percent, to 12,216.96. That's down 4.5% from its record close on February 20. Standard & Poor’s 500-stock index lost over 50 points, or 3.5%. Losses were especially severe in recently high-flying small company stocks and technology issues: The tech-heavy Nasdaq Composite Index dropped nearly 97 points to close at 2407.86, down 3.9%.

The markets opened on a sour note on news that the Chinese stock market fell 9% overnight. The government there said it would take steps to curb speculation in that market, a statement that gave investors here the jitters. Then, the Commerce Department reported that orders for durable goods -- big ticket items like washing machines -- dropped in January by the largest amount in three months. Suddenly, traders were fretting over everything from remarks made by former Federal Reserve chairman Alan Greenspan warning of recession to a suicide bomb attack in Afghanistan.

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The darkest hour came about an hour before the close, when the Dow was down more than 500 points. A technical glitch reporting trades may have exacerbated the drop, but despite a final-hour comeback, the day's finish was the Dow's worst since September 17, 2001, the first trading day after the terrorist attacks, when it lost 685 points. Few stocks withstood the selling storm. Among them: Radio Shack rose $2.68, to $25.13, after reporting better-than-expected earnings; Great Atlantic & Pacific Tea (grocer A&P's parent) rose $2.31 to $33.18 after the company said it was in merger talks. As traders sought the safety of U.S. Treasuries, the yield on 10-year notes fell to 4.5% in the biggest one-day drop since December 2004.

Despite the mayhem on Wall Street, few market experts with a long-term bent were shaken from their basically bullish convictions. "What causes us to feel pretty good is that unless worldwide economic growth is slower and U.S. corporate earnings are cut in half, I think this is going to be a buying opportunity," said Standard & Poor's top strategist, Sam Stovall. Remarked Citigroup chief strategist Tobias Levkovich: "I'm trying to figure out what went wrong fundamentally -- and I'm having a hard time finding it."

Indeed, we see worldwide economic growth reaching more than 3% this year, with U.S. improving 2.8%. That's down from 3.4% domestic growth last year -- but still solid. S&P sees corporate earnings growing at 7.5% this year -- half last year's growth rate, yet presentable. Consumers here and abroad are still buying our goods, and government and business spending is likewise still in good shape.

Nor was the stock market particularly overpriced, as it was before the crash of 2000, say. In fact, the stock market overall is now trading at about 16 times projected 2007 earnings, says S&P's Stovall. The average P/E going back to 1935 is 15.7.

So what went wrong with stocks? A little too much of a good thing, perhaps. While traders had a list of excuses to choose from, the fact is that any of them could have served to allow the market to digest some of its recent stellar gains. Prior to February 27, the Dow had gone for 154 days with out a 2% correction, according to Ned Davis Research -- the second-longest streak on record. (The longest was 177 days in 1953-54.) We’re still in the second-longest streak without a 10% pullback, which started in March 2003. The longest ran from 1990 to 1997. "Correctionless markets breed complacency," says Jim Stack of InvesTech Research. "That complacency can be dangerous when a correction comes. It can make the correction more severe -- more like a sudden stampede for the exits." Hair-triggered hedge funds compound the problem.

Should you head for the exits? Absolutely not. We can't say where the market will go over the next few days or weeks -- and the ride is almost certain to be a rocky one, as volatility in the market is on the rise. But long-term investors shouldn’t be spooked by short-term shenanigans in the stock market. "My guess is this thing won't play out very long -- maybe a month at most," says chief investment officer Jim Paulsen at Wells Capital Management.

In the meantime, a little bargain-hunting might be in order. Citigroup's Levkovich sees good value in semiconductor stocks as the outlook for profit margins improves; telecom stocks look good as pricing power comes back -- you're not getting the deals you once could on cell phones, he points out. Other sectors he likes includes energy companies, with phenomenal cash flow and attractive price levels, and retailers, catering to consumers who just won't stop buying.

Look at it this way: The market is handing you an opportunity to buy something you liked last week at a better price this week. That's no curse. It's a gift.