They were shaken Monday by a plunge in China's Shanghai index, perhaps a sign that the world growth engine could become a little creaky. Then came a prediction about a potential plunge in European stocks from a Morgan Stanley strategist known for prescient forecasts.
In a reaction to that and near $67-a-barrel oil, investors dumped all 30 Dow Jones industrial average stocks. The Dow sank almost 200 points, for a total of more than 400 points this week. And investors sold international stocks, too.
Stock investors don't like it when bond yields go over 5 percent. There is a presumption among them that people, faced with the choice to invest in stocks or bonds, will see bonds yielding more than 5 percent and ask themselves, "Why not be safer and make a little money in bonds?"
If many investors are afraid people will start making the move out of stocks and into bonds, the stock market will go down. But there was more to the fear in the market Thursday than the possible attraction of bonds. The magic word driving the market the past few years has been "liquidity." Virtually anyone who wanted money to buy a house or buy a business or improve a business could obtain money easily and pay low interest rates. Terms were so attractive, people bought more homes and businesses than they would otherwise.
Now, investors are worried that the spigot will be turned down. Higher interest rates could make it less tempting for businesses to do deals. In particular, it could be more difficult to obtain cheap money to buy public companies and take them private. That's a huge concern for investors, because many have been throwing money into stocks the last few months based on one bet -- that someone will come along, buy out the company in which the investor owns stock and leave the investor with a juicy stash.
Merrill Lynch strategist Richard Bernstein warned clients in a note this week that the stock market might not act well if investors start to digest the fact that they have been paying top dollar for stocks on the bet that they will make a quick buck in a leveraged buyout.
"Investors right now can't imagine how the leveraged buyout boom would end," he said. "Rising rates and rising equity valuations could do the trick."
But hedge funds apparently were starting to digest that possibility this week. Hedge funds can bet on stocks going up by taking "long positions" or bet on them going down by "going short."
ISI Group's Hedge Fund survey a week ago showed the highest level of long positions since 2002. One frequent comment was, "It's hard to short an individual security because of LBOs and buyouts," said ISI managing director Oscar Sloterbeck. But this week, hedge funds dropped their long positions in stocks substantially, he said.
Leuthold Group money manager Steve Leuthold grew nervous about stock prices, inflation, interest rates and other signs of a peak in May and cut back exposure to stocks to 50 percent of his portfolio.
According to Leuthold's measures, large-company stocks would have to fall 15 percent to get back to their median prices, and small companies, which have been the stars of the market for seven years, would have to fall 32 percent.
Ned Notzon, manager of the T. Rowe Price Spectrum Growth fund, however, said he won't cut back on stocks. While the market could be in for a near-term correction, he said, he remains enthusiastic about the worldwide economy. He has cut back on small-cap stocks, is overweighting large, fast-growing companies and thinks stocks remain a better buy than bonds.
What does the 10-year Treasury's higher rate mean for you? Find out by going to chicago tribune.com /business to link to Gail MarksJarvis' blog.