Jeremy Siegel, Ph.D. The Future for Investors

When the market moves sharply upward, brokers call it a "bull surge" and attribute it to "waves of optimism." But when markets fall decisively, they call it "volatility," a euphemism for a bear market or downward correction.

There's no question that markets were volatile last week and are likely to remain so in the near future. But I believe that good earnings and low interest rates will still make 2007 a rewarding year in stocks. And despite the fact that virtually all world markets sunk together, international diversification is still as important as ever to the success of investors' portfolios.

Trading Strategies

Whatever you want to call what happened to the market last week, it wasn't pretty. After marching upward for many months with nary a pause, the market suddenly plunged without warning. Why did the market fall and what does it mean?

The truth is that many market movements are not due to economic forces but to traders watching what other traders are doing, or what we call "technical trading." This is largely what happened on Feb. 27, when the Dow Industrials plunged 546 points in the late afternoon before closing down 416 points.

The backdrop is important. The stock market had been steadily rising for seven months. That was the longest period when markets hadn't even corrected by 2 percent in more than a half-century.

When stocks were in this uptrend, the market attracted many "trend followers" or "momentum players." These are speculators who make no judgment about whether stocks are cheap or expensive but only want to jump on the bandwagon. There's an old expression on Wall Street -- "Make the trend your friend" -- and that's just what these speculators did.

But these trend-followers knew that the bull market wouldn't last forever. They protect their profits by placing stop-loss orders below the current price. A stop-loss order tells the market maker to sell whenever the stock penetrates a predetermined level. Because the market never moved down 2 percent for so long, many stop-loss orders were placed 2 percent below the market. Once the 2 percent limit was breached, a wave of selling broke out.

The Straw that Broke the Camel's Back

Any event, however insignificant, could trigger a 2 percent decline. For several weeks, markets had been nervous over defaults in the subprime (below investment grade) mortgage market. On the night before the big decline, China's Shanghai index, reacting to rumors that the Chinese government was going to clamp down on speculation, fell 9 percent, the most in a decade.

Furthermore, there were reports that former Fed chairman Greenspan had said that a recession was a "possibility." Finally, the durable goods report that came out on Tuesday morning showed a much larger decline than the market had anticipated.

Even taken together, these events didn't justify a 400-point drop. The fall in the Shanghai index had followed a record-breaking 130 percent gain in the prior year, and even after the decline, the Chinese market was higher than it was just two weeks earlier. Greenspan said that a recession was only a "possibility" (anything is possible!), and his remarks were actually posted on Monday and the market barely budged. Finally, the durable goods report, though dismal, is a notoriously volatile and, unlike the inflation or employment reports, almost never has a big impact on the market.

Nevertheless, when all these small factors were added together they pushed the market through the 2 percent barrier that speculators had set as a selling point. These trend followers then bailed out of the market, sending the market down another 3 percent in a matter of hours.

Stock Returns in 2007

There's little question that economic growth has slowed over the past several quarters. GDP growth, which had been between 3.1 percent and 3.7 percent over the past four years, has fallen to about 2 percent. The record 19 consecutive quarters of double-digit earnings growth will certainly end this quarter. In fact, current estimates of earning growth in 2007 are only 7 percent to 7.5 percent.

But the market doesn't need double-digit earnings growth -- or a roaring economy -- in order to do well. If the price-to-earnings ratio remains unchanged, the return on stocks will be the earnings growth plus the 2 percent dividend yield. In this case, the market will return a very healthy 9 percent to 9.5 percent in nominal returns and 6.5 percent to 7 percent after inflation. This return is right in line with historical averages and well above bonds.

And there's a good possibility that the price-to-earning ratio will rise, especially if the Federal Reserve lowers interest rates later this year. If the economy is particularly soft, then such a move is a virtual certainty. So if earnings come in under expectations because of a sagging economy, lower interest rates will cushion the impact on the stock market.

Nowhere to Run, No Place to Hide

One of the fascinating aspects of last week's decline was that it was replicated throughout markets worldwide. Every major developed and emerging stock market declined, and all did so by nearly the same magnitude. Some claim that the high correlation between markets means that the purported advantage of international investing, namely diversification, doesn't work. Diversification is supposed to reduce risks by investing in different stocks, sectors, or countries whose returns are not synchronized. If all the markets move together, diversification is lost.

But the very high correlation between world markets only occurs in the short run. This correlation has increased because investors now operate in world markets and easily transmit their hopes and fears to traders in other markets.

Although emotion may rule the stock market in the short run, economics rules in the long run. Long-term returns will vary across countries because of differences in economic policies, currency movements, and sector growth. Don't despair that international diversification didn't cushion last week's decline. It will certainly do so over longer periods.

Final Words

Sell-offs understandably scare investors and garner much media attention. But history has shown that they're excellent buying opportunities.

Given the reasonable levels of today's stock markets, I advise investors to remain internationally diversified and stay with stocks.