The Dow Jones Industrials (^DJI +0.48%) are seen as the primary indicator of how well the U.S. stock market is faring. Yet increasingly, the financial markets worldwide have become much more closely connected, and so when trouble brews in one part of the globe, even the Dow can respond negatively. That was certainly the case during August, when the Dow sported not one but two 500-point daily drops, including the worst performance of 2015: a 588-point decline on Aug. 24. Let's take a closer look at why the Dow fell so far and whether investors should be concerned.
Big trouble in big China
Macroeconomic weakness in China set the stage for the Dow's worst performance of 2015. During the summer months, China's Shanghai index fell 40%, giving up its gains from earlier in the year and raising concerns that the Chinese financial markets were even more unstable than most market participants had already feared. The Chinese government's efforts to support the economy hadn't produced the results that its investors had wanted to see, and the use of margin loans and other volatility-inducing trading methods among China's novice investor base likely exacerbated the declines.
Image source: Wikimedia Commons.
All of this came to a head on Aug. 24, when the Chinese stock market began the day with a decline of 8.5%. The damage earlier that day had been much worse, as trading circuit breakers kicked in to halt buying and selling of shares in hundreds of different stocks. Traders in China ended up calling the day "Black Monday." Stocks in Tokyo also reacted negatively, with the Nikkei 225 (NIKKEIINDICES: ^NI225) falling nearly 5% and hitting their lowest level in six months. European stocks followed suit, with most major market indexes on the continent falling around 5% as well. The ongoing drop in oil prices also reflected fears of a global slowdown and further weighed on stock markets worldwide.
A four-digit drop in the Dow
Perhaps the most important thing about Aug. 24's 588-point drop was that it could have been far worse. Earlier in the trading session, the Dow fell nearly 1,100 points within minutes after the market opened. Even large-cap stalwart stocks like General Electric fell more than 20% for brief moments during the day, creating near-panic conditions and reminding many investors of the infamous Flash Crash in 2010.
The drop also served a vital purpose: It brought about an official correction in the stock market, something that investors had believed was long overdue. Indeed, long-term investors can remember that buying at the bottom of the Flash Crash was immensely profitable, and that likely helped spur the partial comeback that the Dow posted by the end of the trading session. In combination with a 619-point rise in the Dow on Aug. 26, the Dow's bullish investors didn't let the big Monday decline hold them down for very long.
The aftermath of Black Monday
In hindsight, the market was able to recover, and by October, the Dow had erased all signs of its previous decline. Yet what investors focused on the most was the magnitude and speed of the decline and the accompanying disruptions in trading. The use of futures contracts, exchange-traded funds, and more complex trading strategies led many to conclude that there was a near-vacuum of liquidity to open the trading day on Aug. 24, and that was what created the huge air pockets in which stock prices oscillated wildly. Many blamed high-frequency trading algorithms and other automated strategies for the extent of the swings.
Regardless of the cause, the hundreds of circuit breaker-created trading stoppages in individual stocks and ETFs wrought havoc on the way professional traders handle their portfolios. How to handle the interconnections across financial markets remains an open question, because what became clear on Aug. 24 is that shutting down one part of the market while leaving other closely related parts of the market open only creates confusion and the potential for disastrous consequences.
The best takeaway from the Dow's worst day of 2015 is that those who have the discipline to buy into the market at times of maximum fear can count on long-term rewards. Using Aug. 24 as a reminder to beat back your emotions and look for bargain stocks on the cheap is your best lesson from the one-day decline.
