The Dow's Big Drop

Can the market recover from its worst week in five years?

Last Tuesday, the Down Jones Industrial Average dropped 226 points. On Thursday, it dropped 311 points further. On Friday, it dropped another 208 points. The NASDAQ and S&P 500 suffered huge selloffs as well. Wall Street analysts now wonder: have the bulls run away, or is this just a necessary correction to an overvalued stock market?

The bearish scenario. If there is one root factor for the market’s descent in the last five days, it is the presumption that credit standards are tightening, meaning fewer leveraged loans to enable corporate buyouts and a higher cost of capital for companies and individuals. Throw in a sputtering housing market, high oil prices and the possibility of the Federal Reserve raising interest rates upon an improved second-quarter GDP, and the stock market may be poised for a downward phase or a period of stagnation.

The rebound scenario. Here’s the other take on last week: the stock market is more volatile and emotionally driven than ever before, and what happened last week was just the new volatility. As Charles Schwab & Co. director of derivatives Randy Frederick noted, “You look at a 300-point Dow day and it seems like a big day, but from a percentage viewpoint it's not a big move." The major indexes are still up 3-6% this year even with last week’s market shock. Optimists (and realists) believe Wall Street will soon rebound, maybe not next week but in the near future, when postive earnings reports and stimulating economic data appear. In this school of thought, the global economy is so strong that investors will remain bullish through virtually any crisis, and as hard as last week was to accept, it was simply an inevitable response to an overvalued stock market.

Some perspective. What we saw last week was no Black Friday (the day in 1987 when Wall Street sank almost 20% in eight hours), but perhaps a painful new part of the Wall Street landscape. It is worth noting that since 1985, the Dow Jones has grown an average of 8.6% annually – history to cheer any stock market investor. As for where we go from here, the next economic indicator to watch is the next jobless claims report from the Labor Department, which will be released next Friday (August 3).