Add S&P downgrade to a struggling economy, what do you get? Stocks in shock. [VIDEO]

Stocks plummeted Monday, in response to the S&P's decision Friday evening to downgrade the US debt rating from AAA to AA+.

By , Staff writer

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    A broker covers his face behind his screen at the stock market in Frankfurt, Germany, on Monday, Aug. 8, the stock index plunged after the opening of the stock market. The Dow, NASDAQ, and S&P 500 have all fallen in response to the downgrade of the US credit rating.
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In the first trading session since Standard & Poor’s lowered the debt rating of the United States from AAA to AA+, investors reacted badly, selling stocks in waves.

After noon, the widely watched Dow Jones Industrial Average had plunged 318 points to 11,125, as investors ran for cover. Other, broader market indices, including the Standard & Poor’s and the NASDAQ, were sharply lower as well. As its lowest point so far on Monday, the Dow average was off as much as 350 points.

“Investors have a fragile psyche right now,” says Fred Dickson, chief investment strategist at D.A. Davidson & Co. in Lake Oswego, Ore. “Sentiment is extreme on the negative side. Each piece of bad news is causing traders to dump stocks.”

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The selling is a continuation from last week, when the stock market lost about 7 percent of its value. The major averages are now down close to 13 percent from their recent highs. If the selling continues, the market will enter “a bear market” phase, which is loosely defined as a loss of about 20 percent.

Although the stock market has dipped sharply in the past without an adverse effect on the economy, falling stock prices adversely impact business and consumer sentiment. This can eventually spill over onto Main Street, as consumers postpone large purchases like automobiles, and businesses decide to hold off large investments.

“Drops in the stock market do not necessarily translate into a loss of confidence,” says Lynn Franco, director of consumer surveys at the Conference Board, a business research group in New York. “But you have to look at the political scenario, the downgrading of the US debt, and the longer-term repercussions. This will not instill confidence.”

The key factor will be how long the stock market falls. The longer the drop, the worse the impact on consumers’ psyche, says Ms. Franco.

The stock market plunge isn't the only disappointing economic news. On Friday, the Department of Labor reported the US economy added 117,000 jobs in July. Although this was higher than many economists had anticipated, it was still considered a “weak” reading, says Franco.

The soft economic data, combined with the falling stock market, increases the probability the US will slip into a recession, say some economists. Last week, for example, Standard & Poor’s estimated the odds had increased to 35 percent that the US would enter a recession, up from 30 percent.

The US and global economy “are in a feeble ‘rehab’ recovery,” which has been hurt by surging oil prices, the Japan disruption, and the debt crisis in Europe and the US, wrote Bank of America economist Ethan Harris in an analysis on Monday.

Downgrading the US government debt may be the "straw that breaks the camel's back,” said Mr. Harris.

Monday's market unease comes a day before the Federal Reserve meets for its monthly meeting to set short-term interest rates. Although interest rates are already low, some investors suggest thata the Fed may make an effort to calm the financial markets.

“I think they will do something that effectively eases long-term interest rates,” says Eric Stein, vice president and portfolio manager at Eaton Vance Investment Managers in Boston. “The question is, how far do you go right now?”

While the stock market sank, the price of gold surged to more than $1,700 an ounce, up over $60 Monday morning, as investors ran for shelter. “The cost of anything safe is going higher and higher,” says Mr. Stein.

The bond market had very little reaction to the S&P downgrade since many traders had expected the action.

Instead, the bulk of the negative reaction was on Wall Street.

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