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The August Stock Sell-Off

It started when the Dow Jones Industrial Average plunged 400 points in February 2007 after a market meltdown in China. Then, a series of jolts came in July and August as investors worried about the subprime mortgage collapse and a credit crunch. Make no mistake about it, volatility was back with a vengeance. The summertime stock collapse was so unsettling that the Federal Reserve Board felt compelled to ease credit by reducing the bank discount rate—a rare move by the nation’s central bankers. But what does all this really mean, and should you worry? One explanation for the summer’s market turbulence is that, after repeatedly shaking off bad news during the past few years, stocks were simply overdue for a correction. Despite soaring oil prices and military setbacks in Iraq, share prices had pushed steadily higher, and in mid-July the Dow and Standard & Poor’s 500 stock indexes hit record highs. And it had been a very smooth ride. From May 2003 through January 2007, the Dow never dropped more than 2% in a day. That was a period of stock market stability unmatched in more than a century, but it couldn’t last forever. Finally, “the past few years’ speculative excesses were pulled from the market,” says Doug Roberts, chief investment strategist at Channel Capital Research. But the summer stock market was also buffeted by a sudden credit crunch.

When the economy is on the upswing, things often get a little out of hand, and this time that took the form of easy credit being offered to poorly qualified homebuyers in the form of subprime mortgages. When those homeowners couldn’t keep up with their payments, foreclosures began to rise. And because those mortgages had been repackaged into complex, illiquid securities bought by hedge funds and other institutional investors, it was those sophisticated professional investors who suffered the worst losses. With these rarely traded securities still buried in some portfolios, the full extent of the damage may not yet be known.

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