Stocks: Wall Street Hits the Panic Button

The ugly June 6 selloff points up the market's intractable problemslike rising oil prices and a stagnant labor market. Is the bear back?

A frightened Wall Street flooded the stock market with sell orders June 6, sending major indexes plunging 3% and giving investors plenty to ponder over a warm summer weekend.

The big question: Is this a temporary mood swing for a nervous market? If so, fear may dissipate, and the market has a chance to quickly bounce back when better news headlines come along next week.

Or, did something fundamental change on June 6, a day when oil prices spiked $11 per barrel and a jobs report showed the unemployment rate jumping from 5% to 5.5%, the largest rise in 22 years?

Waking Up to a New Reality

Many market observers believe it is the latter: The stock market is catching on to a new, scary reality.

Yes, the worst fears about financial crisis are fading three months after the collapse of investment bank Bear Stearns. But now the focus is on the economy, which remains fragile, and especially inflation, which appears to be heating up.

Making the day's news all the more surprising, the outlook for the economy and inflation seemed to improve in recent weeks. Many pieces of data for May looked better than expected, like retail sales figures and the Institute for Supply Management's manufacturing index, suggesting the economy—while weak—was not in a recession. And, after rapidly rising to a record $135 per barrel, crude oil prices backed off recently, raising hopes that the speculative fever in the commodity markets was cooling off.

What Does the Jobs Report Really Mean?

Both reasons for optimism collapsed June 6, as the Dow Jones industrial average dropped 394.64 points, or 3.13%, to 12,209.81, while the broader Standard & Poor's 500 fell 43.37 points, or 3.09%, to 1,360.68.

Economists debated the true meaning of the May jobs report, as pieces of data gave different pictures of the U.S. economy. But for many, the headlines told the story: The unemployment rate rose by 0.5%, the biggest monthly jump since 1986.

First American Funds (FAF) Chief Economist Keith Hembre warned that such a big jump in the unemployment rate is very troubling. "It's pretty hard evidence that this is a recessionary environment, albeit pretty mild," Hembre says.

Defying the Laws of Supply and Demand

Even if the economy continues to grow slowly in 2008, the rising jobless rate suggests it could be a tough year for many Americans. Michael Strauss, chief economist at Commonfund, expects a "growth recession. It looks, feels, and acts like a recession, but [economic growth] is above zero," he says.

For all the concern about the economy, investors seemed even more unnerved by the surge in oil. After oil backed off recently, "most people thought the pressure was off," says Bill Stone, chief investment strategist at PNC Wealth Management (PNC).

On the Nymex June 6, crude oil for July delivery hit a record of $139.12 before ending the day at $138.54, a $10.75 increase. There were several explanations for the big move, including a Morgan Stanley (MS) analyst's prediction that crude would hit $150 by July, and tough talk toward Iran by an Israeli cabinet member, which raised tensions in the oil-rich Middle East.

George Soros Blames Speculators

Whatever the reason, oil doesn't seem to be obeying the usual laws of supply and demand, Strauss says. Americans are cutting back on driving and other energy use, for example, but oil continues to rise. "We don't appear to be trading on supply-and-demand relationships," Strauss says. "We seem to be trading on supply-and-demand fears."

Billionaire trader George Soros told the U.S. Senate on June 3 that the price of oil was a "bubble" driven mostly by speculation. Others seemed to agree, as the oil markets calmed earlier in the week. If there was a ray of hope that speculative fever might leave energy markets, that faded June 6. "Whatever is driving oil prices, it's not going away," says Dan Genter, president of RNC Genter.

High energy costs would slow the economy even further. "If [oil] sticks at this level, you've got to be concerned about future economic growth," Stone says.

Hoping for a Blowoff

Rising commodity prices also add to inflation worries. Inflation, in turn, could prompt the Federal Reserve to quickly raise interest rates later this year. "That will shock the market," Genter says.

One hope for the stock market is that oil's runup is a "blowoff rally." That is Morgan Keegan Chief Technical Strategist John Wilson's term for one last rally before oil prices quickly collapse and speculators flee the market all at once. "I think crude could drop $20 or $30 in a heartbeat," Wilson says.

Another hope for stock investors is that the market is simply overreacting. "I don't think the world changed today," says John Merrill of Tanglewood Capital Management. Oil's surge may be temporary, and plenty of other economic data suggests the economy is holding up O.K., he says.

Investors must hope that the market is focusing far too much on a couple of nasty news headlines—news that will be soon forgotten. But the fear is that those headlines are merely a harbinger of worse things to come.

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