Making Sense of the Stock Drop

Stocks’ sharp decline on Thursday just compounded growing concerns that the 6-year-old bull market is on wobbly legs. Here are answers to some common questions investors may be asking.

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Q So stock prices are pulling back. Isn’t that healthy?

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A That’s one way to look at it. Some analysts have been arguing that the market’s record highs of recent months put many stocks at “overvalued” levels, at least using historical benchmarks of prices relative to earnings, dividends, interest rates, etc.

So a pullback could correct some of that alleged excess, setting the stage for another rally later on. The question is how far prices need to fall before buyers reemerge in large numbers.

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Q Aren’t these pullbacks pretty typical within bull markets?

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A They used to be--in the 1960s, ‘70s and ‘80s. But one of the hallmarks of the 1990s bull market has been that prices, on average, haven’t given much back.

Wall Street used to count on blue-chip stock indexes such as the Standard & Poor’s 500 declining 10% to 15% every few years as investors took profits. But in the 1990s bull market, which began in October 1990, the S&P; index has yet to pull back more than 10%.

So far this year, the S&P; index has declined just 5.2% from its record high reached Feb. 18.

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Q So a 10% decline in the S&P; would be normal?

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A Yes. But, of course, some stocks could fall much more than that. Many issues are already down by at least that much: The Nasdaq composite stock index is down 10% from its record set in mid-January.

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Q What is behind the market’s current weakness?

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A The better question to ask might be, what isn’t? Besides the fact that many stocks have been selling near or above all-time highs in terms of price-to-earnings ratios, interest rates have risen in the bond market over the last month, anticipating that the Federal Reserve Board would tighten credit--which it did Tuesday, for the first time in two years.

The Fed’s goal is laudable enough: slow the stronger-than-expected economy before it begins to spark higher inflation.

But higher interest rates are almost never good for stock prices. They make bonds better competition for investors’ dollars, and they raise the cost of borrowing, thus crimping some companies’ profits. So naturally, as rates move up, investors lower the prices they’re willing to pay for stocks.

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Q OK, but shouldn’t the same strong economy that is pushing rates up translate into robust corporate earnings, helping stocks?

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A That’s the hope. Some analysts believe first-quarter earnings will be fairly healthy, reminding investors of the ultimate reason they own stocks: to share in companies’ profits.

In 1994, interest rates surged, but the stock market ended with only small losses for the year. The big reason: Corporate earnings soared.

The differences now are that stocks are sharply higher than they were in 1994 and earnings growth isn’t nearly as strong, in part because most companies have fewer ways to cut costs than they did in 1994, 1995 and 1996.

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Q What’s the worst-case scenario for stocks?

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A Some analysts argue that a full-fledged bear market--usually defined as a decline of more than 15% in blue-chip indexes--can’t occur unless the economy is in danger of overheating, then falling into recession.

But investors also should realize that the 1990s bull market has gone on for so long, and built up such large gains for many investors, that anything is possible now. It might not require much profit taking by mutual fund owners, or institutional investors, to produce a rapid decline in share prices--a “crash,” in other words.

If you have a truly long-term time horizon--at least five years, and hopefully 10 to 20 years--stocks’ short-term trend shouldn’t worry you. But if you need your capital soon, you should think now about whether you could afford to temporarily lose 20% to 50% of your money in a sudden bear market.