By Elizabeth MacDonald

The Dow’s 354-point plunge Thursday was the worst drop since the presidential election. FOX Business Network stocks editor Elizabeth MacDonald weighs in below on what's behind the decline and what to expect when the market opens:

The markets overreacted Thursday on the Federal Reserve’s signal it may withdraw from its stimulus. Traders are seeing any downdrafts as a buying opportunity for lots of stocks, which still remain on certain valuation measures at their cheapest levels since 1954. Ending artificial stimulus is a good thing. Investors can better figure out which companies have solid earnings growth, it’s back to fundamentals. It will stop the artificial bubbles in commodities and emerging markets.
 
The Fed pullout is a sign the economy is getting stronger, that’s nothing to fear - and all of that is good for stocks. The Fed pullout is also causing a natural correction in overbought currencies and lower-quality corporate bonds. The point of the U.S. central bank’s intervention was to reflate assets, and the economy, including housing. But not all boats deserved to be floated higher (does the Fed now have a triple mandate, not a dual mandate, of inflation and job growth?).
 
For a month and a half now, Wall Street has been in an uproar about the Federal Reserve’s plans to scale back printing money to buy $85 billion bonds, as many on the Street fear a terrific bull market for the past four years is coming to an end. The Fed’s money has leaked into the stock market, as returns on things like bank deposits are microscopically low. That’s why, even with today’s downdraft, the market is still up about double digits this year, still in shouting distance of the record it hit on May 28. But here’s the back story to the “stop the market, the Fed wants to get off” routine: Even the most unreconstructed bull has to agree the markets may have gotten ahead of the economic recovery, the slowest since World War II. That’s why we have these emotionally wide trading swings. Even so, the Fed thinks the U.S. economy is recovering to grow at a 3% annual rate. With faster economic growth comes higher inflation in the form of higher prices, which increase corporate profits, which are good for stocks.
 
But not so good for borrowers are higher borrowing rates, which are pegged to the 10-year bond, already at a 14-month high jumping to 2.4%, which is still historically low. A 3% U.S. GDP growth rate means the 10-year bond yield should go up to 5%. That’s still low, too, historically. When this bond moves higher, so do loans pegged to it. And besides, the central bank has already said it will raise rates if the economy improves.
 
Housing is in recovery, but it’s now questionable whether a rate hike would put it back on its heels, since loan rate increases may force borrowers to get up off their seats and into buying houses, which is likely why new and existing home sales numbers have been improving. But again, the central bank’s coming slow-down was telegraphed already by various Fed governors who gave speeches indicating the central bank would make this move fairly soon, as unemployment came down to 7%, which the central bank thinks might happen next year. The jobless rate is down to 7.5% from 7.8% when the Fed ratcheted up its bond buying in September 2012.
 
Here’s what’s worth keeping in mind: Stocks are still cheap at 15.5 times earnings, which is lower than the 17.3 median since 1993, and lower than the average going back to 1954. Despite the Fed bond purchases, equity valuations generally haven’t moved higher. Stocks are multiples cheaper than when they were in bubble territory in the late 1990s, and in 2004. Companies have cleaner books, less accounting shenanigans, they’re making real profits. They are sitting on around $1.8 trillion in cash, which could be deployed in a market downturn to buy stocks on the cheap.
 
Also, a footnote: The Fed can always restart its bond buying again as it’s done before if the economy slows down, joblessness moves higher and inflation remains weak.    

Related Articles
  1. Active Trading Fundamentals

    Giants of Finance: Charles Dow

    Find out how this financial visionary helped everyday people enter the world of finance.
  2. Bonds & Fixed Income

    How Now, Dow? What Moves The DJIA?

    Find out how this index tracks market movements and where it falls short.
  3. Investing Basics

    Understanding And Playing The Dow Jones Industrial Average

    Learn strategies for investing in this price-weighted index and how to interpret its movements.
  4. Professionals

    What to do During a Market Correction

    The market has corrected...now what? Here's what you should consider rather than panicking.
  5. Professionals

    Tips for Helping Clients Though Market Corrections

    When the stock market sees a steep drop, clients are bound to get anxious. Here are some tips for talking them off the ledge.
  6. Stock Analysis

    The Safest Stocks You Can Invest in Right Now

    These stocks are likely to hold up better than others in a bear market, but there's a twist.
  7. Investing Basics

    5 Reasons to Expect Lower Stock Returns

    Lower stock returns are likely here to stay for some time. Here are five reasons why.
  8. Investing

    Finding Value in the Selloff Rubble

    Globally and in the United States, stocks are now in correction mode, with the recent erosion in equities in emerging markets and Europe in a bear market.
  9. Stock Analysis

    Benefits of Regional Bank ETFs over Commercial Banks

    The SPDR S&P Regional Banking ETF offers a stable local alternative to broad-based multinational commercial banking sector funds.
  10. Investing News

    What Shook the U.S. Stock Market Today?

    What was looking as a decent year for US Stock market has suddenly gone off track as the Dow Jones Industrial Average plunged 531 points in the week ending August 23, 2015.
RELATED TERMS
  1. The New Deal

    A series of domestic programs designed to help the United States ...
  2. Agency Swap Program

    A form of securitization whereby single-family residential mortgages ...
  3. Fractal Markets Hypothesis (FMH)

    An alternative investment theory to Efficient Market Hypothesis ...
  4. Marginal Propensity to Save

    The proportion of an aggregate raise in pay that a consumer spends ...
  5. Outcome Bias

    A decision based on the outcome of previous events without regard ...
  6. Predictive Analytics

    The use of statistics and modeling to determine future performance ...
RELATED FAQS
  1. What causes a significant move in the stock market?

    There is a nearly infinite number of factors that can cause the stock market to move significantly in one direction or another. ... Read Full Answer >>
  2. What's the difference between the Dow Jones Industrial Average and the S&P 500?

    The major difference between these two indexes is that the Dow Jones Industrial Average (DJIA) includes a price-weighted ... Read Full Answer >>
  3. How can I use a regression to see the correlation between prices and interest rates?

    In statistics, regression analysis is a widely used technique to uncover relationships among variables and determine whether ... Read Full Answer >>
  4. What are the major laws (acts) regulating financial institutions that were created ...

    Presidents George W. Bush and Barack Obama, in conjunction with Congress, signed into law several major legislative responses ... Read Full Answer >>
  5. What are some of the limitations of run rates?

    Some limitations of a reliance on run rates include the occurrence of one-time sales, limitations on contracts, seasonality, ... Read Full Answer >>
  6. What are some real-life examples of the 80-20 rule (Pareto Principle) in practice?

    There are a number of practical applications for the 80-20 rule in diverse areas such as the distribution of wealth in economics, ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!