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Markets

What's Behind the Selloff?

The decline had little to do with fundamental issues. It was all about market dynamics.

Up a staircase, down an elevator. This is an old Wall Street expression for what happens when a steady climb in the stock market ends. Before the recent correction, the market had gone seven months without experiencing even a 2% downturn -- the longest such period in 50 years. But on February 27, the Dow Jones industrials fell 416 points, the biggest point decline since 9/11. From that day to March 5, the Dow plunged 582 points, or 4.6%.

The decline had little to do with economics or other fundamental issues. The events mentioned as likely causes -- former Fed chairman Alan Greenspan's suggestion of an imminent recession, the drop in Chinese stock prices and a dismal durable-goods report -- were insufficient, even taken together, to justify the market rout.

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The real culprits

Instead, it was all about market dynamics. A steady upward movement in prices attracts momentum players who bet that the trend will continue. To protect their profits, these trend-followers place stop-loss orders that trigger if the market falls by 2%. When the market fell below that level, the rush of sell orders sent prices plunging.

Sharp trend reversals are historically common. In the 1920s, speculators jumped into the bull market, borrowing 90% of the money they invested from brokerages. When the market fell by 10%, as it did in October 1929, brokerages sold their customers' shares to protect the capital they had lent. But as prices continued to fall, brokerages as well as speculators went bankrupt.

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Massive selling, in this case of stock-index futures, also caused the record 22% crash of October 19, 1987. At the time, the popular strategy was "portfolio insurance," based on the belief that you could protect your profits by selling index futures contracts when the market fell. But portfolio insurance worked no better than stop-loss orders, and prices plunged a mind-boggling 15% in a few hours.

The same phenomenon can happen in reverse during a bear market. In the early 1930s, many people were convinced that the market would continue to sink, and they sold stocks short, a bet on falling prices. As prices fell, they tried to protect their profits by placing buy orders a few percentage points above the market, to cover their losses if stocks headed upward instead. From September 1929 through July 1932, the Dow collapsed nearly 89%, but stocks recorded daily gains of 5% or more 21 times.

The common factor among these violent fluctuations is that they were generally not caused by fundamental economic news. Since 1885, the Dow has experienced daily moves of 5% or more 126 times. Of these, only 30, or fewer than one in four, can be linked to a specific event, such as war, political change, financial dislocations or a shift in government policy. Volatility is usually caused by traders reacting to emotions rather than to rational decision-making.

The U.S. economy is experiencing a mid-cycle slowdown primarily because the Fed raised short-term interest rates from 1% to more than 5% over the past two years. The slowdown will cut corporate earnings growth in 2007 to about 7% and break the string of 19 consecutive quarters of double-digit percentage earnings gains. Yet if the market's price-earnings ratio remains constant, stockholders will still earn a healthy 9% return this year, if you add a 2% dividend yield to the assumed earnings growth.

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Fed to the rescue

If the economy weakens more than expected, earnings could be more sharply curtailed and perhaps even fall. But if that happens, the Fed will almost certainly cut rates -- which would lead to an expansion in P/Es, cushioning any fall in stock prices.

What does all this mean for investors? Even with an economic slowdown, stocks still offer good value. Stay with stocks, and even add to your holdings if you have the stomach for volatility. The stock-market elevator has almost reached the bottom floor, and there will soon be a new staircase leading shares upward.

Columnist Jeremy J. Siegel is a professor at the University of Pennsylvania's Wharton School and author of Stocks for the Long Run and The Future for Investors.