Wednesday, February 28, 2007

Stocks' Great Wall of Worry

News Analysis
February 28, 2007

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Stocks' Great Wall of Worry

China's 9% market plunge and U.S. economic concerns led to Dow and S&P free falls. Analysts say it's about time

If Wall Street was overdue for a pullback, it might not be anymore. On Feb. 27, the Dow Jones industrial average and the broader Standard & Poor's 500 index suffered their worst day since Mar. 24, 2003. How much further the market has to fall could depend on the strength of upcoming economic reports.

Tuesday's decline marked an end to a remarkably tranquil eight-month run for stocks. The Dow had gone without a drop of 2% or more since July 17, 2006, only to tumble 3.29% in the latest session. The market's slide puts the Dow on pace for its first monthly loss since June, 2006, and the S&P 500 for its first since last May.

The slide may have awakened investors to the market's inherent risks, after weeks of growing complacency. The Chicago Board Options Exchange Volatility Index (VIX), a measure of investors' risk tolerance often classified as a "fear gauge," surged more than 60% Feb. 27, its biggest-ever increase. The VIX had fallen as low as 8.6 as recently as Dec. 18, 2006, down from a 52-week high of 23.81 set last June.

A sharp overnight drop in China's stock market helped jump-start Tuesday's sell-off. Still, analysts say a weak manufacturing report and broader economic worries were probably more to blame for U.S. losses. Now might be an opportune moment for investors to make sure their portfolios reflect their risk-tolerance levels, though market pros say it's no time to panic just yet.

"It's more opportunity selling right now than anything," says Chris Johnson, CEO and chief investment strategist at Johnson Research Group. "I don't think you can call it a perfect storm that's going to cause us to go down 10%, but certainly the market was in need of a break."

A Sudden Correction

China's stocks posted their biggest one-day drop in a decade (see, 1/27/07, "A Rough Day for China Stocks"). The Shanghai composite index tumbled 8.8% on Feb. 27, its steepest decline since Feb. 18, 1997. Moves by the People's Bank of China to reduce liquidity contributed to the blowout for the market, which reached a record high a day earlier.

Last spring, a drawdown in liquidity precipitated a two-month correction (see, 6/9/06, "A Global Assault on Inflation"). A tightening spree from New York to Tokyo, along with surging oil prices, played a role in last year's short-lived pullback.

China's problems are likely to stay more contained, analysts say. In Hong Kong, the Hang Seng index slid 1.76% on Feb. 27, a much less dramatic drop than in the other Chinese bourses, which have more restrictions on international investment. For U.S. investors, the pullback may have merely provided "an excuse to take some profits" after so many months without a correction, says Jeffrey N. Kleintop, chief investment strategist at PNC Wealth Management (PNC). "I wouldn't chalk it up to more than that."

Meanwhile, economic worries were also weighing on U.S. investor sentiment. On Feb. 26, former Federal Reserve Chairman Alan Greenspan warned a recession is "possible" later this year. A day later, a report showed durable good orders plunged much more than expected in January. At the same time, concerns mounted surrounding the troubled subprime loan market, with mortgage lender Freddie Mac (FRE) announcing tougher lending standards.

Risk Reminders

The slowing economy may represent a bigger potential setback for the market than China's regulatory efforts. The pullback was a "reminder that there's lots of risk in the world and the markets don't just go in one direction," says Barry Ritholtz, chief market strategist at Ritholtz Research & Analytics. "I'm much more concerned about housing and about durable goods than I am about China."

Investors face a full plate of economic data in the days ahead. On Feb. 28, the docket holds revised numbers on fourth-quarter gross domestic product and the January reading of the Chicago purchasing managers' index of industrial activity. Reports on vehicle sales, personal income and spending, construction spending, and national manufacturing activity are due later in the week, followed by nonfarm payrolls data on March 9.

The market may have already discounted weaker readings on some of those reports. A recent rise in index put activity, or bets against the stock market, could signal stocks won't have as far to fall if economic data disappoint, notes Todd Salamone, senior vice president at Schaeffer's Investment Research. "I think the pullback will represent a buying opportunity," Salamone says.

Future Volatility

In the meantime, geopolitical uncertainties compounded the market's Feb. 27 stresses. A Taliban suicide bomber reportedly attempted to kill Vice President Dick Cheney in Afghanistan. Separately, Iran continues to defy international authorities with plans to expand its uranium enrichment program.

The sell-off will continue if investors start to acknowledge higher levels of risk by becoming more cautious, some analysts say. Investors should watch whether private equity takeover activity slows going forward, observes Quincy Krosby, chief investment strategist at the Hartford (HIG). "If we start to see any hesitancy in that, you've got one of the main catalysts for the market on the side," Krosby explains.

What about China? The fundamentals that powered emerging markets' surge over the past few years remain steady, market pros say, but investors must be willing to withstand the region's ongoing volatility. "The case for emerging markets is more solid than at any point in modern history," says Rob Brown, chief investment officer at Genworth Financial Asset Management (GNW).

It's too soon to know whether the one-day pullback is the beginning of a broader correction or just a hiccup. Still, investors might not need to hold their breath just yet.

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