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

by Marc Hogan

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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 BusinessWeek.com, 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 BusinessWeek.com, 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.