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What's going on?
What's going on is that the market has suffered its worst two-week drop in more than three years. After beginning a steady rise in early 2003, the declines in the past two weeks have been precipitous: The S&P has dropped nearly 50 points since May 1, The Nasdaq has fallen 8.6 percent since May 8 and the Dow industrials are down 4.7 percent since hitting a six-year high on May 10. These are the biggest downdrafts we've seen in a long time, and the main question on investors' mind is just how bad this will be. They're wondering whether this is a blip that will reverse its course over the next few weeks, whether it is a market correction, or whether the current turmoil signifies something bigger: the beginning of a cyclical bear market, which is typically defined as a decline of 20 percent or more. Some doomsayers are even starting to draw links between the state of the market and economy now and the climate just before the October 1987 stock market crash.
What's the Fed's role in all of this?
In a word: huge. Speculation about the Fed's moves is precisely what helped drive the market up so far this year and what motivated some investors to start cheering as recently as a few weeks ago that the Dow would soon hit 12,000. Investors thought, and hoped, that the Fed would stop raising rates, which it began doing in June 2004.
But just as investors thought the Fed was ready to take a breather, inflation, which has been lurking as a background threat for months, has suddenly become a bigger concern. Last month the consumer price index rose faster than expected, and in each of the past two months, "core" inflation — which is inflation excluding food and fuel — has increased more than two percent from a year earlier. That's higher than previous indicators, and more importantly, it's above where the Fed is comfortable. That prompted the Fed on May 10 to raise rates for the 16th straight time, to 5 percent, and to signal in its official announcement of the increase that in fact it may not be finished its business. So now, at a time when everyone was getting ready to cheer the long-awaited end of the Fed's rate hikes, the sentiment has gone the other way entirely, prompting big sell-offs.
All of this would be less problematic if U.S. economic growth weren't already slowing. Higher interest rates and energy prices are cutting into consumer spending; as anyone who's tried to put his or her home on the market lately can attest, a cooling housing market hasn't helped either. The one-two punch of rising inflation and a slowing economy puts the Fed in something of a jam. Does it prioritize controlling inflation, or spurring growth? The answer will likely have a big effect on the market and right now, the market seems to be voting the Fed will rein in inflation.
Should I be worried?
Well, maybe. While the nervousness has been enough to send markets across the globe falling, too, a lot rides on what happens over the next several weeks. If the Fed pauses at its next meeting (or even at the one after that) investors may cheer and race back into the market. And it's important to remember that there are some positive things going on, too. Global economic growth is strong, corporate profits are surging, and many investors see stock prices as highly attractive right now. The S&P trades at 17 times earnings right now, down from 20 a year ago and a five-year average of 29. Despite the nervousness and the skittishness, even as they grope for clarity, many investors can't help but see an immediate silver lining: a whole lot of cheap stocks.
Leigh Gallagher is a senior writer for SmartMoney magazine and a regular contributor to "Cavuto on Business."