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Stock market 'correction' or something worse? We may know soon enough

June 2, 2011 |  6:00 am

U.S. economic data have been weakening for months. But it all finally seemed to hit home on Wall Street on Wednesday, sending the Dow Jones industrial average to its worst one-day loss since August.

A 279-point, 2.2% drop in the Dow is bound to get people thinking about the worst-case scenario -- including that this could be the start of a new bear market, just two years after the last one ended.

Yet the market's slide could turn out to be just a garden-variety "correction" that drives out the nervous and gives braver investors a chance to get in at cheaper prices.

A few points of reference to help investors get their bearings:

Dow30 1) The market hasn't fallen much so far. At Wednesday's close of 12,290 the Dow (charted at right) was off 4.1% from its nearly three-year high of 12,810 set April 29. Most other major indexes also hit their 2011 highs on April 29. Since then, the Standard & Poor's 500 is off 3.6%; the Nasdaq composite also is down 3.6%; the S&P 400 mid-cap index is off 3.9%; and the Russell 2,000 small-stock index is down 5.1%.

So if you feel the need to pare back, prices still are near their spring highs. A diversified portfolio hasn't surrendered a lot on paper.

2) A typical correction within a bull market can shave 10% to 20% off the indexes from their highs. That's what happened a year ago, also as the economy was slowing.

The Dow fell 13.6% from its April 2010 high to its low in July. The S&P 500 slumped 16% and the Russell 2,000 dropped 20%. Then the selling ebbed and buyers came back in.

3) The definition of a bear market varies, but generally if the S&P 500 were to fall more than 20% you'd hear Wall Street declare that the bull run that began in March 2009 was over. Reaching that threshold could be devastating for investor psychology because many will remember how a drop of 20% in the fall of 2008 became a loss of almost 50% just a few months later.

But the 2008-09 market collapse coincided with the economy's collapse. This time around the economy hasn't fallen off a cliff, though the recovery clearly has dimmed this spring.

The housing market is heading into a double-dip as prices sink and demand remains moribund. But the manufacturing sector still is expanding, albeit at a much slower pace. Consumers still are spending, though more cautiously. And corporate earnings overall continued to rise in the first quarter, which is a big reason many institutional investors have been reluctant to jettison stocks even though they know the economy has lost momentum.

4) The burden of proof now is on market optimists to show that the recovery can make it through this "soft patch" without giving way to a new recession. That's why the economic data of the next few weeks will be critical, including this Friday's May employment report.

One of the main arguments of stock market bears is that the economy has merely been propped up by the Federal Reserve's easy-money policy, including its $600-billion Treasury-bond-buying program that is scheduled to end June 30. If the economic data worsen significantly Wall Street will again look to the Fed for help.

That could slow any further market drop if investors wait to see what the Fed's response will be.

But politically it could be very difficult for the Fed to launch another stimulus program. And Wall Street's deepest fear is that the central bank could try something else -- only to find that its credibility with investors has all but evaporated.

Fed Chairman Ben S. Bernanke has got to be praying that the economy starts to show that it's stabilizing. There's a lot more than stock prices riding on that now.

-- Tom Petruno