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Wednesday, February 28, 2007 - Page updated at 12:00 AM

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Steep drop is no time for investors to panic

Seattle Times business reporter

Tuesday's dramatic drop in stock markets around the world doubtless has left many people wondering just what happened, why it happened, what's likely to come next — and what it means for their personal investments and retirement funds. Let's try to sort things out:

How significant were Tuesday's market declines?

Pointwise, this was the seventh-largest decline in the Dow's 110-year history. But in percentage terms, the Dow fell 3.29 percent, not even close to a record.

The biggest one-day crash in recent history — Oct. 19, 1987 — wiped out nearly a quarter of the Dow's value. And the first day the markets reopened after the Sept. 11 attacks, the Dow dropped 7.1 percent.

It also helps to put Tuesday's plunge in the context of the overall market gains. Over the past four years, the Standard & Poor's 500 has risen an eye-popping 69 percent.

"For a properly diversified investor with a long-term investment horizon, I don't know that a 3 percent move down — in the context of a really good past four years — is meaningful," said Stephen Wood, senior portfolio strategist for Tacoma-based Russell Investment Group.

This seemed to come out of nowhere — did it?

Not really. Many market watchers, even the most bullish, have said stocks were due for a pullback. Until Tuesday, there hadn't been a one-day drop of 2 percent for more than eight months.

"It's been over four years since we've had a 10 percent correction, and it's certainly a normal, healthy part of a bull market to have a correction of that magnitude," said Peter Glidden, regional vice president for Harris Bank in Seattle.

Hold on. How can it be good for stock prices to go down?

When stocks are going up and the Dow seems to be hitting a new high every other day, it's to be expected that more and more people will want in on the action. Ultimately, however, stock prices have to reflect the underlying value of their companies. If they get too far ahead, you're setting up for a horrific crash like the one in 2000 that smashed the dot-com bubble.

Periodic corrections take some of the hot air out of the markets, Glidden said, and ease the speculative pressure that can pump up stocks to unsustainable levels. He calls it "backing and filling" and uses a construction metaphor: "If you were to build a skyscraper as quickly as you could, it might get up there, but it wouldn't be built on a very solid foundation."

Does this sudden drop mean stocks, the economy, or both, will crash?

Despite increasing concern among traders that the U.S. economy could fall into recession this year, the forecast of most economists is for continued, albeit slower, growth.

Russell's Wood, in fact, said Tuesday's dive might provide a boost for the economy, if it removes the risk that the Federal Reserve will resume raising interest rates. (Some investors worry that to combat inflation, the Fed will raise rates and risk sending the economy into recession.)

And, Wood said, despite the run-up of stock prices, corporate profits have grown even faster. Back in the spring of 2000, before the tech bubble popped, the S&P 500 was trading at around 33 to 35 times expected profits.

Today, the S&P 500 is trading at 16 to 17 times expected profits. By that standard, Wood said, stocks are cheaper now than they were in 2000.

That doesn't mean Tuesday's decline will be a one-time thing. Fred Dickson, chief market strategist for the D.A. Davidson brokerage in Lake Oswego, Ore., said he wouldn't be surprised if stocks continued lower for a few days — though he added, "I don't see this as a multiweek or a multimonth event."

One catalyst could come in the form of today's revised estimate of economic growth in the fourth quarter of 2006. Most observers expect the initial estimate of 3.5 percent to be cut, but if it comes in a percentage point or more lower, that could fuel recession fears and spark another sell-off.

So, what should I do?

The first rule, as it is in so much of life, is: Don't panic. The biggest mistake is buying when the market is going up — i.e., when stocks are expensive — and selling when the market is going down — i.e., when stocks are cheap.

At the very least, Wood said, this might be a good time to rebalance — checking to see if the market's run-up has left some of your stock categories or other asset classes making up more or less of your portfolio than you intended. You can then buy and sell strategically to rebalance it.

And, Glidden said, if there are stocks you like that are suddenly cheaper than they were 24 hours ago, you might want to assess if they're worth buying now or wait to see if they fall much further.

Provided you're investing for the long term and not looking to make a quick buck, he said, the current pullback "could provide you with an attractive entry point."

Drew DeSilver: 206-464-3145 or ddesilver@seattletimes.com

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