Global markets plunge - What happens next

May 27, 2006

The plunge in the stock market last week can be attributed to a release of a buildup that has been occurring over the last six months or so. As we have been saying all along, the large U.S. current account deficit provides a base of uncertainty that makes the markets, and your retirement holdings, more volatile. Three things occurred that ultimately led to last week’s market panic:

• On May 10th, Federal Reserve Chairman Ben Bernanke signaled that he may not increase the Fed Funds rate in June. Although this initially spurred the market upwards, it also signaled that he might not have the experience or wisdom to walk that fine line between supporting the economy and controlling inflation.
• On May 17th, the Labor Dept. reported that inflation was higher than anticipated. The April Consumer Price Index was 3.7% higher than a year ago, and core inflation, which doesn’t include volatile food and energy prices, was 2.3%, which is above the 2% that most economies worldwide have agreed is the goal.
• On May 18th, the Treasury released a report that strongly urged China to increase the value of the yuan. This reiterated previous government and IMF statements that the U.S. Government would not support the dollar, and in fact would prefer a dollar decline to reduce the U.S. current account deficit, and increase exports.

The result was a widespread selloff among all markets, including U.S., international, bonds, and commodities.

What it Means:
The stock market has been going great guns since last fall, and has not had a 10% correction during this time, which is unusual. In addition, the summer is usually when the market declines, and investors know this. Third, the market is reaching its all time high, and will take time to punch through that level.

Finally, there has been excess liquidity throughout the world, as central banks flooded global economies in reaction to the recession of 2001. As banks now raise rates to mop up this liquidity and prevent inflation, markets will react by slowing down. In this case, the slowdown occurred strongly in one week, instead of over a longer period of time. What will happen next? Most likely the dollar will decline, interest rates will rise, and investment returns will be slower for the rest of this year.

Action Steps:
The temptation during a strong market decline like this is to sell and stem further portfolio declines. However, that’s called trying to time the market, and most individual investors will end up selling low and buying high.

Instead, remember that retirement investing is for the long haul. If you have a well diversified portfolio, parts of it will recover while other parts decline. That is the advantage of diversification - less risk. Furthermore, if you are on a payroll deduction plan at work, you are continuing to buy funds at these lower prices.

The fundamentals of the global economy have not changed dramatically over the last week, and the market will continue to return to a mean. If you are really concerned, talk to your financial advisor about what they think the long term prospects are, and make sure you are, in fact, well diversified. But whatever you do - Don't panic.

Source: Federal Reserve Press Release, Bureau of Labor Statistics, Consumer Price Index