What really happened to stock market on 2/27/07?

As billions of dollars came out of the world’s stock markets last week, the money didn’t just evaporate. It is trying to decide where to go.

The economy continues to grow, generating profits. Market interest rates remain low- in fact they have been falling again- making it cheap to borrow money. So there is no shortage of cash.

Analysts see at least three ways to view last week’s trouble, which resulted in a 4.2% drop in the Dow Jones Industrial Average. Goldman Sachs economists Ed McKelvey and Andrew Tilton outlined three competing views in a report last week.

1. A much-overdue short-term pullback.
The DJIA had not fallen as much as 2% from a high in more than 7 month, hadn’t fallen 10% in almost 4 years. That is an exceptionally long time without a serious hiccup.

If last week’s trouble was just a hiccup, then stocks should rebound in the next few weeks, and the trick is to pick out the stocks likely to rebound the most.

2. A flight from risky investment.
If that is what is going on, then the market shift is more serious.

Investors suddenly have pulled back from a raft of risky securities, from developing-country stocks and bonds to junk bonds and small stocks in the U.S.

Harc Stern, Chief Investment Officer at Bessemer Investment Management in New York. His view is that investors had become blasé about risky securities, paid too much for them, and now are seeing the prices of those assets fall back to a more normal level. He thinks risky investments could fall further. He says he likely will buy larger, blue-chip stocks that can withstand the possibility of more stormy weather as the year progresses.

“Some of the easy money that went else where may be coming back to the U.S.” says Richard Sichel, CIO at Philadelphia Trust, who also thinks the stocks of big U.S. multinational companies could come back into favor. Big stock generally have lagged behind other investments, but the bulls think they will come into their own now.

Nervousness about risk also is evident in the way investors have been using stock options. For months, investors didn’t fell much need to buy and sell stock options to protect themselves from sudden market changes. An index measuring the use of options, Vix tracked by Chicago Board Options Exchange, has been unusually low for months. Last week it jumped 70%, an almost unheard-of gain in % terms. In absolute gain, the Vix is still well below its historic average.

3. A sign of a weaker economy to come.
Th is could be the most troubling prognosis. Some investors took former ED chairman Alan Greenspan at his word last week when he said a recession later this year couldn't be ruled out. These investors see the flight to bonds as another sign conservative investors are hunkering down for a period economic trouble.

Until last week, investors who had bet on a softening economy hadn’t done very well. Consumer spending and corporate profits repeatedly have come in stronger than most pundits expected. Reports of the consumer’s demise have been exaggerated.

Despite this, the Goldman economists say in their report that they think economic growth, the housing market and consumer spending all may be softer this year than more bullish analysts are forecasting. They also don’t rule out the possibility that default problems in the lower end of the mortgage market could bleed into other lending markets.

The Goldman economists see a silver lining: They expect the Fed to step in by June and being cutting its target interest rates. Today, with economy appearing to be growing more like 2% than 3% annually, bond yields and interest-rate futures suggest many investors think the Fed will cut rates by summer to give the economy a boost.

Lower interest rates support stronger economic growth. They also support home sales because they make it cheaper to invest inland and to take out a mortgage.

And cheap money makes it easier for people to borrow money and invest in financial markets. A big source of support for the stock market over the past four years, and for a wide variety of riskier investments, has been the huge amount of cash sloshing around, looking for a place to go. The availability of cheap money has made investors a lot more comfortable about taking risk.

As long as the Fed is expected to cut rates- rather than raise them, as it was doing in 2000, when the last bear market began—the cheap money can continue supporting stocks. Cheap money would help offset some the worries these days about slowing economic growth, a credit crunch, a weak housing market and investor exposure to risky asset.