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Understanding the stock market's nosedive

The stock market ended the month of July with the Dow Jones Industrial Average dropping by 317 points in one day. At 1.88 percent, that's not an earth-shattering drop by stock market standards, but it was enough to get investors worrying -- and the pundits scurrying.

As dramatic as a big one-day drop seems, 1.88 percent should not radically alter the course of anyone's investment program. Still, the implications of the July 31 decline were magnified by the fact that this drop wiped out all of the market's progress for the year so far and threatened to touch off a subsequent wave of volatility.

Figuring out what to do next starts with having a clear understanding of what just happened. Unfortunately, dramatic market events generate a lot of noise, so the first step is to sift through the good and bad explanations of why the market took a sudden nosedive.

Searching for real answers

Here are some of the explanations that were given for the stock market's end-of-July misadventure, along with comments on whether these seem to be relevant to the state of the market going forward:
  1. August is often a bad month. The premise is that investors got a jump on this supposed inevitability by getting out the day before August started. Yes, people actually say things like this with a straight face, but you should consider it more trivia than investment insight.
  2. The stock market was due for a fall. The stock market has had an impressive run, with five consecutive positive years, and it has more than doubled since hitting bottom in early 2009. Still, rising prices themselves are not a reason for a subsequent drop, but they are a measure of risk. High market valuations are like being high up on a ladder: It does not mean you are necessarily going to fall -- just that the consequences are more severe if you do.
  3. The Fed may be getting ready to raise interest rates. Yes, low interest rates have helped fuel the market rally, but fear of the Fed raising rates arises from recent evidence of a strengthening economy. If true, that should have an offsetting positive impact on company earnings.
  4. Inflation is rising. A second-quarter surge in prices and deepening troubles in energy-producing parts of the world could add up to a reason for interest rates to rise without the offsetting benefit of stronger growth. This is shaping up to be a genuine problem.
  5. Argentina's default raises credit concerns. Given its reputation as a bad credit risk, Argentina's decision to stiff a couple of hedge funds that invested in its bonds should not come as a big surprise -- there is a reason Argentina had to rely on hedge funds to fund some of its debt in the first place. However, with staggering amounts of debt around the world, this is the kind of thing that can touch off a chain reaction. Expect nervous investors to demand higher interest rates going forward.

The combination of those last two elements makes it seem likely that interest rates will be higher at the end of the year than they are now. That prospect should not only factor into your decisions about the stock market, but also your choices regarding mortgages, savings accounts and CDs.

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