May 21, 2010

Stocks in the U.S. and around the world have fallen sharply over the last month, partly due to concerns that the Greek debt crisis could lead to weaker economic growth in Europe and derail the global recovery. While major U.S. equity indexes have dropped at least 10% from their late-April highs—the traditional definition of a “correction”—investors may be wondering how they should respond to this significant pullback that follows a year of brisk gains. While no one knows how long or deep this downturn will be, T. Rowe Price’s portfolio managers and financial planners believe that investors should remain focused on their long-term financial goals and maintain their asset allocation.

From their closing peaks in 2007 through the close of business on March 9, 2009, several major U.S. equity indexes fell 50% to 60%—one of the worst bear markets since the Great Depression.

	Dow Jones Industrial	S&P 500 Index	Nasdaq Composite Index	S&P MidCap 400 Index	Russell 2000 Index
Losses from 2007 closing highs through 3/9/09 closing lows	-54%	-57%	-56%	-56%	-60%

Index returns are based on price movements only and do not include dividends. It is not possible to invest in an index.

Dow Jones Industrial Average: A stock index composed of 30 major U.S. companies.
S&P 500 Index: A 500-stock index of mostly large-cap U.S. companies.
Nasdaq Composite Index: An index that tracks U.S. stocks traded in the over-the-counter market.
S&P MidCap 400 Index: A 400-stock index of mid-size U.S. companies.
Russell 2000 Index: A stock index composed of 2,000 small U.S. companies.

From the close of business on March 9, 2009, through their late-April 2010 closing highs, major large-cap indexes rallied 70% to 80%. Small- and mid-cap benchmarks fared even better, surging more than 100%, as shown in the table below. The government’s efforts to stimulate the economy, stabilize the financial system, and increase credit market liquidity, as well as better-than-expected corporate earnings, were some of the main catalysts for the rally. While the rebound has been astounding, in late April the major indexes were still about 10% to 20% below their 2007 highs.

	Dow Jones Industrial	S&P 500 Index	Nasdaq Composite Index	S&P MidCap 400 Index	Russell 2000 Index
Gains from 3/9/09 closing lows through April 2010 closing highs	71%	80%	99%	110%	116%

Index returns are based on price movements only and do not include dividends.  It is not possible to invest in an index.

Throughout U.S. stock market history, the market's long-term ascent has been punctuated with downturns that vary in terms of length and magnitude. In general, corrections tend to occur more frequently but are milder and shorter than bear markets-generally defined as a pullback of at least 20%. Considering the magnitude and speed of the market's ascent from March 2009 through April 2010, it is reasonable to expect stocks to go into reverse for some period of time.

After an extended period of steady equity market gains, some investors may feel that a 10% drop in the market over four weeks is abnormal. In fact, stock market corrections have occurred with great regularity. Brian Rogers, T. Rowe Price's Chairman and Chief Investment Officer, discourages investors from reading too much into the recent drop in the market. "Global markets have had an unbelievable advance over the last year, but corrections are nothing new, and investors shouldn't overreact to the ebbs and flows of the markets. They are quite normal."

T. Rowe Price’s U.S. equity portfolio managers remain optimistic about the fundamental environment for equities. They note that the economy is expanding and believe it is more resilient than many realize. Corporate profits are growing again, and cost-cutting has enhanced the financial footing of many firms. The capital markets are functioning normally (unlike in late 2008), and there is still significant investor cash on the sidelines that is not invested in the markets.

At the same time, T. Rowe Price equity managers acknowledge several concerns and potential risks that could temper their favorable outlook. Unemployment remains high, and new regulations could go too far and stifle vital sectors of the economy. A potential increase in income and capital gains taxes next year could have a material impact on investors. In addition, there are questions about the federal government’s ability to rein in debts and deficits, as well as the Federal Reserve’s ability to manage monetary policy without derailing the recovery or letting inflation take off.

T. Rowe Price’s financial planners acknowledge that it’s easy for investors to feel compelled to do something—such as adopt a more conservative asset allocation—when their investment values are declining. “Investors are strongly motivated to avoid losses,” says Financial Planner Stuart Ritter, “But doing what feels good financially in the short term may make you feel even worse in the long term.”

Judith Ward, a senior T. Rowe Price financial planner, suggests that investors focus on their own portfolios, rather than the daily headlines. “During periods of heightened market volatility, the best approach is to make sure that your portfolio is well diversified and that your investments are appropriate for your goals. If you are truly diversified, your portfolio is not necessarily mirroring what you hear in the news.”

Ward offers some broad guidelines to help investors with varying time horizons determine if or how they might respond to the current downturn in the market.

• If you have many years before reaching your goal—15 or more, for example—you have the time to weather these types of short-term swings in the market. Now is not the time to abandon a strategy that has significant exposure to the stock market. For perspective, consider that the S&P 500 Index produced an average annual total return of 7.66% during the 15-year period ended April 30, 2010—a period that included two severe bear markets.
• If your investment horizon is shorter than 15 years, you should be well diversified with a mix of domestic and international stock and bond investments.
• If you need or plan to use the money in your account in the near term, you shouldn’t be investing in the stock market at all.