Stocks plunge on fears of a 'full-blown recession'

Stocks fell sharply on a variety of factors – from a pessimistic Federal Reserve to reports that Europe might be headed for a recession. But falling stocks don't guarantee a recession is coming.

On Thursday, the fear of a global recession began to shake the financial markets.

That fear led to a near-stampede as many investors tried to sell stocks no matter what the price.

By the end of the day on Thursday, the Dow Jones Industrial Average had lost 391.01 points, or 3.5 percent of its value, after falling 283.82, or 2.5 percent, on Wednesday. The Standard & Poor’s index, which hit a one-year low, and the Nasdaq also plummeted.

“It’s a mess,” says Phil Flynn, senior market analyst for PFG Best in Chicago. “There is not a lot of optimism out there.”

David Kotok, the president of Cumberland Advisors in Vineland, N.J., says the markets “are reacting as if a full-blown recession is coming.”

As investors sold their holdings, they shifted into government bonds, which pushed the yield – the percent return on the investment – on the 10-year Treasury note to a record low of 1.8 percent. The rush into US government securities pushed the dollar sharply higher. Commodity prices such as gold and oil plummeted.

The mood had darkened on Wednesday after the Federal Reserve said “there are significant downside risks to the economic outlook, including strains in global financial markets.”

Scott Brown, chief economist at Raymond James & Associates in St. Petersburg, Fla. thinks investors “got spooked by the tone of the Fed’s economic outlook.”

It did not help when the mood at the meeting of the International Monetary Fund and the World Bank, which opened on Thursday, was decidedly grim. World Bank President Robert Zoellick said the world economy remains in a “danger zone.”

"I still think a double-dip recession for the world's major economies is unlikely, but my confidence in that belief is being eroded daily," said Mr. Zoellick.

On Thursday, the news was not especially good coming out of Europe. Economic data indicated manufacturing and service activity fell in August for the first time in two years. According to an analysis by Barclay’s Capital Research in New York the data indicate the manufacturing sector in Europe “is set to experience recession,” considering a significant gap between new orders and inventories.

If Europe does go into a recession, Mr. Brown does not expect the US will be able to escape some of the fallout.

“Partly, it will be trade with Europe, partly financial turmoil,” he says.

At the same time, European leaders are still struggling with ways to prevent Greece from defaulting on its sovereign debt. The prospect of a default hanging over the market, combined with the steep sell-off on Thursday, may keep many investors on the sidelines on Friday, opines Anthony Valeri, a market strategist at LPL Financial in San Diego.

“Traders don’t want to have any risk over the weekend,” he says.

Although some economic forecasters believe the US has already entered an economic downturn, most still think the US is on course for a period of very slow economic growth.

One of those who believe the US will avoid a recession is Mr. Kotok of Cumberland Advisors. “No one is crazy enough to say we will have robust growth,” he says. "In our view we will have 1 percent to 2 percent growth, but we won’t have quarter after quarter of negative gross domestic product.”

To try to stimulate the economy, on Wednesday the Federal Reserve announced it would start to shift its own portfolio of bond holdings from short term to longer term, buying $400 billion in longer term US Treasuries through June of next year.

“The Fed has done all it can do,” says Kotok. “But Congress is in a fiscal mess, offsetting all the good the Fed has done.”

On Thursday, the House failed to pass legislation that would have funded the US government through mid-November because the legislation, which had already passed the Senate, failed to pay for disaster aid. However, many observers expect the House will find a compromise with the Senate and will not shut down the government. Nevertheless, government spending is expected to fall sharply next year and is expected to be a drag on the economy.

In a typical recession, earnings drop 13 percent on average, says Mr. Valeri. That would correlate with the S&P 500 being about 1120, close to where it closed on Thursday. “At that point the market has priced in a recession,” he says. “We are getting very close to that.”

However, falling stocks alone don’t mean the economy is going into a downturn. There have been times when the stock market swooned by 20 percent but there was no recession, Kotok says.

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