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Yesterday's plunge in stock prices around the world, including the steepest percentage decline in the Dow Jones Industrial Average in nearly four years, signals that investors may finally be reevaluating their insatiable appetite for risky investments.
The catalyst was Tuesday's nearly 9% fall in stock prices in Shanghai, one of the hottest and most volatile markets in the world. That helped send U.S. stocks on a roller coaster that ended with the DJIA down 416.02 points, or 3.3%, to 12216.24.
For a moment yesterday it looked even worse. Just before 3 p.m. Eastern time, the Dow plunged more than 200 points in minutes, to a low of 12086.86, after a technical glitch delayed the reporting of its true value.
For months, global stock markets had been pointing almost straight up, ignoring admonitions from Cassandras that investors were excessively complacent about the risks they were taking. The amount of compensation, in the form of higher yields, that investors usually demand for lending money to riskier companies or countries had been shrinking steadily. And with credit plentiful and cheap, private pools of capital have been borrowing to buy up bigger and bigger companies. Even prices of art and wine have been soaring.
The mood changed sharply yesterday. And the setback was widespread. Major stock-market indexes in France and Germany fell 3% each, Britain's fell 2.3%, Turkey was down 4.5% and Brazil plunged 6.6%. The sell-off roiled Asian markets as trading opened on Wednesday. In Tokyo, the benchmark Nikkei 225 Stock Average fell 3.9% to 17,417.14 after less than an hour of trading.
The question now: Was it a one-day hiccup, or the beginning of something more lasting?
The atmosphere began to shift Sunday night, New York time, when former Federal Reserve Chairman Alan Greenspan, speaking by satellite to a Hong Kong audience, used the word "recession" and appeared to question the widespread notion that the current expansion will last all decade, much as the expansions of the 1990s did.
"We do not and cannot look into history without being very concerned when you see the absence of awareness and concern about risk that we see today," Mr. Greenspan told his Hong Kong audience.
Stocks didn't flinch at first. But on Tuesday, a day after hitting a record high, the Shanghai Composite Index fell 8.8%, its biggest drop since jitters about the 1997 death of Communist Party elder Deng Xiaoping, for no obvious reason. Analysts suggested investors wanted to get out of the soaring market before the Chinese government made any moves to cool the markets, such as by introducing new trading taxes.
Then in the U.S., the Commerce Department made Mr. Greenspan appear prophetic yesterday morning with its report that orders for big-ticket factory goods fell sharply in January. That raised questions about the strength of capital spending, a factor the Fed, among others, has been counting on to offset housing-market weakness.
About the same time, mortgage lender Freddie Mac said it was tightening standards on subprime loans. That was just one more sign that the market for loans to the least creditworthy borrowers is deteriorating rapidly. Defaults are up. Lenders' shares are down. The prospect that lenders will grow increasingly tight-fisted has raised concerns that the worst isn't yet over for the housing sector, which has been showing some signs of stabilizing.
A weaker-than-expected U.S. economy could undermine many assumptions that have been underlying investors' embrace of risk. It could lead to higher defaults among companies that have taken on large amounts of debt. And it could undermine the outlook for foreign markets, which tend to depend far more on the U.S. economy than the U.S. depends on theirs.
Despite yesterday's financial-market turmoil, there is little sign the prognosis for the U.S. economy has changed much. Strong readings on home sales in January and consumer confidence in February suggested the U.S. economy may be growing at about a modest 2% annual rate, but that it hasn't downshifted much from that. "The growth situation is not great, but I don't think it's much different from what the Fed has been anticipating for a while," said Stephen Stanley, chief economist at RBS Greenwich Capital.
Still, corporate-profit growth, in double digits for more than three years, is showing signs of falling back to single digits this year. In the fifth year of a bull market, money managers increasingly have been worrying that stocks are overdue for a significant pullback. So they have been poised to sell at the first sign of real trouble.
The shift in sentiment comes amid proliferating signs that central bankers — many of whom have been fretting that investors' love of risk could reverse suddenly — are ready to tighten the credit spigot.
The Chinese central bank has been trying to cool lending. The Japanese central bank recently raised interest rates — albeit to just 0.5% from 0.25% — in part to discourage speculative borrowing in its markets. The European Central Bank yesterday reported that money supply grew at its fastest rate in 17 years in January in countries that use the euro, a trend that could argue for higher European rates.
The major exception is the U.S. Fed, which appears to be on hold for the foreseeable future. Though it has a bias to raise rates again if inflation worsens, futures markets are betting the next rate move is a cut.
The signs of nervousness reached well beyond stocks, as the U.S. dollar, for instance. U.S. Treasury bonds rallied sharply in an apparent flight to safety, as investors reacted to worries such as the stock-market turmoil, weakness in U.S. manufacturing and concerns about the subprime mortgage market. The 10-year Treasury note's yield — which falls when the note's price rises — fell to 4.47% at one point. The Treasury note's yield ended the day at a two-month low of 4.515%.
Investors dumped bonds of developing countries, sharply widening their yields compared with U.S. Treasurys, which represent the safest debt instruments. This so-called "spread" widened by 0.14 percentage point — a major increase — as investors demanded higher returns for owning the riskier assets. Some investors in these emerging markets believe a correction is long overdue. "We need to be paid a lot more for the additional risk we are taking," said Andrew Feltus, a bond-fund manager at Pioneer Investments in Boston.
In another sign of risk aversion, the Japanese yen strengthened more than 2% against the U.S. dollar, its biggest jump in about a year. Global speculators have for years been borrowing yen, taking advantage of Japan's low interest rates, and then investing in markets that promised higher returns. The practice is known as the carry trade. It has been an emblem of investors' seemingly limitless appetite for risky strategies in recent years.
Yesterday's tumult spurred some traders who used this strategy to begin reversing it. That meant closing out some of their riskier investments and putting the money back into yen — thus giving the yen a boost. These sales by investors engaged in the carry trade apparently contributed directly to the global stock declines yesterday.
Treasury Secretary Henry Paulson briefed President Bush on the stock market. Mr. Paulson didn't make any public comment, and a Treasury spokeswoman said he didn't convene a call of the principals of the President's Working Group — the heads of the Treasury, the Fed and Securities and Exchange Commission.
Yesterday was the heaviest trading day ever for stocks listed on the New York Stock Exchange. Total trading in these stocks was 4.07 billion shares. It was so heavy that some investors found it tough to process "buy" and "sell" orders. One trader said he was unable to fill all his orders on the NYSE trading floor in the last 15 minutes of the trading day. Instead, he was rerouting orders to alternative electronic venues away from the Big Board. "We just hit a brick wall," said Stephen Porpora, an NYSE floor broker with William O'Neil. "These markets move faster than anyone can."
With increased electronic trading — in which stocks are bought and sold by computer instead of on a traditional trading floor — traders "can't slow things down" as they used to when a crush of activity loomed, Mr. Porpora said. At around 3 p.m. he saw the Dow slip by more than 100 points in seconds as he tried to trade a large, volatile stock. One order entered around 3:58 p.m. took 10 minutes to process, even though the market officially closes at 4 p.m., he said. Usually, trades are processed in two or three minutes.
Volatility, which has been tame for months, soared yesterday, as measured by the CBOE Volatility Index.
It all made for a hectic day for traders. Jack Ablin, chief investment officer at Harris Private Bank in Chicago, was sitting in the waiting room of his doctor's office, waiting for a stress test, when his trader sent an urgent email: "The market is down 500 points."
Mr. Ablin, who manages $50 billion, said he looked at the email and thought, "What am I missing?" The news from China "went from a blip to a tidal wave" in a matter of moments, catching Mr. Ablin by surprise. After receiving good news from his doctor after the test, Mr. Ablin returned to his office and began compiling a list of blue-chip stocks that he planned to begin buying today, he said.
China's impact on the day's events is remarkable on several counts. Shanghai's so-called A-share market is largely closed to foreign investors, and local speculators who make up its primary investors typically pay little attention to factors outside of China.
Chinese share prices, after years in the doldrums, have soared for much of past 20 months — a rally that has prompted millions of Chinese to take up stock trading. Officials have expressed concern about the pace of the runup, after the benchmark index surged 130% in 2006.
Traders said the index's close above 3,000 earlier this week made them nervous that the government would have added reason to adopt new taxes or other measures to apply brakes to the market when China's legislature convenes next week for its annual session. The Chinese government, however, yesterday denied rumors that it was considering a 20% capital-gains tax on stock investments in bid to prevent market from overheating, the state-run Shanghai Securities News reported.
The long rally has made China's stock market more important globally. Many of the world's best-performing mutual funds last year targeted stocks of Chinese companies listed overseas. And, while foreign investors have little direct access to domestic Chinese stocks, that market's rising value and influence reflects broader growth in the importance of China's $2.7 trillion economy.
Traders in Hong Kong are particularly attuned to mainland China, since some of its largest stocks are also listed in Shanghai, including big banks and insurers. Hong Kong's blue-chip Hang Seng Index lost 1.8% Tuesday to 20,147.87.
China's stock market long has been divorced from the underlying economy, with share prices undergoing several boom and bust cycles even as growth has hummed along with remarkable consistency. As China's economic boom made many of its citizens wealthier in recent years, most Chinese ignored stocks and instead spent money on apartments, new cars, and new businesses.
The market's rapid rise since mid-2005 has made stocks an increasingly important part of the lives of many Chinese. The gains have been fueled by millions of new investors — from retirees to college students — who have poured into street-level brokerage outlets to sign up for trading accounts. Online trading is gaining in popularity too. Since Chinese stocks rarely sell for more than a few pennies a piece, barriers to entry are low and as many as 90,000 accounts have been opened per day in recent weeks.
Chinese have plenty more money to invest. In total, individuals in China still sit on about $2 trillion in bank deposits — far more than the $1.4 trillion in combined market capitalization for China's two stock exchanges, in Shanghai and Shenzhen.
—Gregory Zuckerman and Aaron Lucchetti contributed to this article.
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