Dow’s Plunge Is Puzzling

The August swoon of the stock market, which has sent the Dow Jones industrial average down 6.8 percent in just seven trading days, has stunned Wall Street in large part because there is no easy explanation for it.

“The selling has been relentless, against the backdrop of very good news,” said David Shulman, the chief equity strategist at Salomon Brothers.

That good news has included the best inflation news in years, along with reports of gains in productivity.

And it has included a reduction in the capital gains tax that had long been sought by Wall Street.

What is clear is that investors have grown a bit less willing to send money to mutual funds. In the week ended Wednesday, some stock funds saw net withdrawals of money for the first time in months, according to AMG Data Services.

That coincided with the enactment of the new tax law, and it is possible that some investors decided to take profits at a time when the capital gains tax rate, on stocks owned for more than 18 months, is down to 20 percent. There had been talk about such selling, but most analysts had expected it to be minimal.

Wall Street has not seen the Dow fall as much as 6.8 percent in seven trading days since the spring of 1994, when rising interest rates were blamed as the culprit. This time, interest rates have risen, but not by huge amounts. In fact, long-term interest rates fell a bit last week, even as the Dow was having its worst week since 1990.

It is possible that warnings about stock market valuation are finally having some effect. By many measures, stocks are the most expensive they have ever been, although many Wall Street analysts have defended such valuations as being justified by the strong economy and absence of inflation. And it may be that some investors recall that it was almost 10 years ago, in August 1987, that the market peaked, only to fall 36 percent over the next eight weeks, culminating in that year’s crash.

The recent selling has been the most dramatic among some of the largest, best-known and heretofore most successful stocks, the types of blue-chip stocks that had risen as money poured into index funds that bought all the stocks in the Standard & Poor’s index of 500 stocks.

Gillette, for example, fell more than 5 percent Friday after it warned that sales overseas were lower than expected. Similarly, Coca-Cola had led the market lower the previous Friday after it warned that profits would lag expectations.

So far, the falls have been largely confined to the bigger stocks. The Russell 2,000 index, which is made up of 2,000 companies whose market values are less than those of the top 1,000 companies in the country, is down just 2.9 percent since the peak last week, less than half as much as the Dow has lost. And while the Nasdaq composite is down 4.2 percent, the bulk of that loss has been accounted for by a few large companies that had previously been very strong.

Moreover, the decline has only reversed the gains of a few weeks. At the peak, the Dow was up more than 50 percent - or 2,900 points - from the low reached in July 1996. The index closed lower than its current level as recently as June 30.

Still, for investors who might be inclined to worry, the latest slide has shown how fast profits can vanish in some stocks. Microsoft is down 12 percent from its high, while Merck has fallen 16 percent. Coca-Cola and Gillette are each down 19 percent. All, however, are still up at least 10 percent since the end of last year.

One reason to hope for a revival on Monday is that much of Friday’s fall - 113 of the 247 points the Dow lost - came in the final half-hour of trading. And much of that may have been related to selling based on the expiration of some stock index futures and options contracts at the close of trading Friday. Such activity can cause markets to move farther than they otherwise would, in which case much of the move is often retraced when markets reopen the following week.

But the real question, regarding whether the latest fall will turn into something significant or just be reminiscent of the spring swoon when the Dow fell almost 10 percent in a month, only to quickly recover, lies with individual investors.

Since the market recovered from the 1987 crash, individual investors have treated market weakness as a buying opportunity and have put in money even when the professionals who manage that money have grown nervous. If that trend continues, prices will soon begin rising again.