U.S. stocks drop 5% after opening, but it could be worse

NEW YORK -- The Dow Jones industrial average came off its lows but was down 300 points to 8,370 in early trading, its lowest level in 5 1/2 years amid rising fear that the global economy is in for a deep recession.

U.S. stocks followed Asia and Europe lower.

Diving stock prices are being driven by emotion and fear in a bear market that just seems to get worse, says Andy Brooks, head trader at mutual fund giant T. Rowe Price.

"It is pretty serious," says Brooks. "Stocks around the globe are down 9%." Stocks fell 9.6% in Tokyo, 8.3% in Hong Kong and were down only slightly less in major European markets.

The key to the day, says Brooks, "is what stocks do after the open" on Friday.

The Dow, which was 550 points below Thursday's close in futures trading before the opening bell, seemed to be holding up fairly well, considering the steeps drops around the world.

Another bright spot is that both the Dow and the broader Standard & Poor's 500 index are still trading above their intra-day lows — 7773 for the Dow and 839.80 for the S&P — hit during the panic-led sell-off on Friday Oct. 10.

Much of the selling has been driven by global deleveraging, a process in which investors sell securities to reduce risk and lower their exposure to financial markets.

Investors are still unsure how far along in the deleveraging process we are. It is made worse because many big investors, such as hedge funds, were invested with borrowed money, which amplifies losses.

As is often the case when stocks drop precipitously, investors are hoping Friday's drop marks the final day of capitulation — a day when all the panicky investors who want to get out finally sell, and get out, says Brooks. That type of selling has paved the way for market bottoms and recoveries in past bear markets.

"The key to the day will be to see some real emotional selling," says Brooks. "Everyone wants the throw-in-the-kitchen-sink-type trading day. That would be healthy. There is some real panic and emotion and that often signifies a capitulation."

With the Dow now down more than 41% from its Oct. 9, 2007, high, some investors say this is the time to buy, but only if investors have the stomach to deal with crazy volatility and have a long time horizon.

Stock prices, says Brooks, already reflect a pretty bad economy.

Stocks in the S&P 500 are currently selling at less than 10 times their earnings projections for 2009. That is close to the bottom of the 1973-74 bear market, when the index average bottomed at seven times earnings. Stocks are already selling at lower valuations than they were after the 1987 stock market crash.

Todd Leone, head trader at Cowen & Co., says Wall Street is nervous, and "bracing for the worst" as the trading day moves forward Friday.

But, Leone says, investors are "hoping that we get selling capitulation and that we bounce back."

Despite all the fear, Leone says many stocks are good buys, after having being beaten down the past year.

Much of the selling is by investors who can no longer cope with the violent price swings and steep losses, Leone says. "People are just getting out," he says.

Selling is also being driven by hedge funds, or private investment funds, that have suffered big losses this year. They are forced to sell their investments to raise cash for redemption requests from unhappy investors to meet margin calls.

So how low is low? Some market analysts who use stock price charts to glean future market direction, say it is possible for the Dow to test its lows hit in the last bear market in late 2002 and early 2003. That area is around 7500 on the blue chip average. The Dow would have to fall roughly 10% more to hit that level, which some analysts say should serve as a floor for prices.

"It's not inconceivable that we go back and test the lows we say in 2002 and 2003," says Todd Salamone, analyst at Schaeffer's Investment Research. "

Overseas, Japan's Nikkei stock average fell a staggering 9.60% overnight. In afternoon trading in Europe, Germany's benchmark DAX index was down 9.4%, France's CAC40 was down 9% while Britain's FTSE 100 was 8.4% lower after third quarter GDP fell 0.5%, putting that country on the brink of recession.

The big drop in futures trading raised the possibility that circuit breakers intended to prevent panic selling could be triggered during regular trading — something that hasn't happened since 1997.

If the Dow Jones industrial average falls 10% before 2 p.m., the market will shut down for an hour. If the threshold is breached between 2 p.m. and 2:30 p.m., the halt will last 30 minutes. Trading would stop again if the Dow falls 20%. If trading falls 30% at any time, trading would be halted for the day. The market usually closes at 4 p.m.

On Thursday, the Dow rose 172 points as investors went looking for bargains after two days of selling. Analysts have predicted that trading will remain volatile for the foreseeable future while investors test whether or not the market has hit a bottom.