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Is the Drop in Financial Markets an Overreaction?

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Stunned investors are now wondering whether the markets' big selloff was an overreaction or a sign of more volatility to come.

Global financial markets plunged Thursday after the Federal Reserve roiled Wall Street by saying it could reduce its aggressive economic stimulus program later this year. Concerns about China's economy heightened worries.

The global selling spree began in Asia and quickly spread to Europe and then the U.S., where the Dow Jones Industrial Average fell 353 points, wiping out six weeks of gains.

(Read More: After Drubbing, Can Stocks Find a Footing?)

But the damage wasn't just in stocks. Bond prices fell, and the yield on the benchmark 10-year Treasury note rose to 2.42 percent, its highest level since August 2011, although still low by historical standards. Oil and gold also slid.

"People are worried about higher interest rates," said Robert Pavlik, chief market strategist at Banyan Partners. "Higher rates have the ability to cut across all sectors of the economy."

The losses extended into Asia early Friday. Hong Kong's Hang Seng tumbled 1.5 percent, while South Korea's Kospi declined 2 percent. Japan's Nikkei 225 index, the regional heavyweight, fell marginally.

So what next? Traders and investors are looking for a new equilibrium after a period of ultra-low rates, due to the Fed's bond-buying, which helped spawn one of the great bull markets of all time.

It doesn't mean the stock run-up is over. After all, the S&P 500 is still up 11.4 percent for the year and 135 percent since a recession low in March 2009. But it may suggest the start of a new phase in which the fortunes of the stock market are tied more closely to the fundamentals of the economy.

And that might not be a bad thing. The reason the Fed is pulling back on the bond-buying is because its forecast for the economy is getting brighter.

The job market is improving, corporations are making record profits and the housing market is recovering.

(Read More: Gold Now at Levels Worse Than April's Big Selloff)

"People are overreacting a little bit," said Gene Goldman, head of research at Cetera Financial Group. "It goes back to the fundamentals, the economy is improving."

The Dow's drop Thursday—which knocked the average down 2.3 percent to 14,758.32—was its biggest since November 2011. It comes just three weeks after the blue-chip index reached an all-time high of 15,409. The index has lost 560 points in the past two days, wiping out its gains from May and June

The S&P 500 lost 40.74 points, or 2.5 percent, to 1,588.19. It also reached a record high last month, peaking at 1,669. The Nasdaq composite fell 78.57 points, or 2.3 percent, to 3,364.63.

Small-company stocks fell more than the rest of the market Thursday, a sign that investors are aggressively reducing risk. The Russell 2000 index, which includes such stocks, slumped 25.98 points, or 2.6 percent, to 960.52. The index closed at a record high of 999.99 points Tuesday.

The yield on the 10-year Treasury note rose to 2.42 percent, from 2.35 percent Wednesday. The yield, which rises as the price of the note falls, surged 0.16 percentage point Wednesday after the Fed's comments. As recently as May 3, it was 1.63 percent.

A Fed policy statement and comments from Chairman Ben Bernanke started the selling in stocks and bonds Wednesday.

Bernanke said that the Fed expects to scale back its massive bond-buying program later this year and end it entirely by mid-2014 if the economy continues to improve.

The bank has been buying $85 billion a month in Treasury and mortgage bonds, a program that has made borrowing cheap for consumers and business. It has also helped boost the stock market.

Alec Young, a global equity strategist at S&P Capital IQ, said investors weren't expecting Bernanke to say the program could end so quickly, and are adjusting their portfolios in anticipation of higher U.S. interest rates.

"What we're seeing is a pretty significant sea-change in investor strategy," Young said

For much of the year, the stock market rose with barely an interruption. The S&P 500 climbed for seven months straight from November 2012 through May. Investors, fearful of missing out on the rally, pounced on any dips and pushed markets to record highs. On Thursday, those opportunistic buyers were absent. Nobody wanted to stand in the way of the market's slide.

As investors sold stocks, they likely put the proceeds in cash "for fear the deterioration will continue," said Quincy Krosby, a market strategist at Prudential Financial.

The sharp increase in bond yields prompted investors to sell homebuilders, whose business could be hurt if the pace of home buying slows down. Those stocks fell Thursday even though the National Association of Realtors said U.S. sales of previously occupied homes last month topped 5 million at an annual rate for the first time in 3 1/2 years.

PulteGroup plunged $1.89, or 9.1 percent, to $18.87. D.R. Horton fell $2.13, also 9.1 percent, to $21.31.

(Read More: Fed Shakes Global Markets as Interest Rates Rise)

Markets were also unnerved after manufacturing in China slowed at a faster pace this month as demand weakened. That added to concerns about growth in the world's second-largest economy. A monthly purchasing managers index from HSBC fell to a nine-month low of 48.3 in June. Numbers below 50 indicate a contraction.

A big jump in the overnight lending rate in China also unsettled investors, said Brad Reynolds, a financial adviser at LJPR. The rate measures how much banks charge each other to borrow short-term money. The People's Bank of China was forced to pump about 50 billion yuan, about $8 billion, into the Chinese financial system to alleviate the squeeze, Bloomberg News reported.

Before trading began Thursday on Wall Street, Japan's Nikkei index lost 1.7 percent. The FTSE 100 index of leading British shares fell 3 percent while Germany's DAX dropped 3.3 percent.

In currency trading, the dollar rose to 97.34 Japanese yen from 96.54 yen. The euro fell against the dollar, to $1.3197 from $1.3274.

Gold plunged, leading a rout in commodity prices. Gold dropped $87.80, or 6.4 percent, to $1,286.20 an ounce. Silver fell $1.80, or 8.3 percent, to $19.823 an ounce. Both are at their lowest since September 2010.

Traders dumped gold and silver as their appeal as insurance against inflation and a weak dollar faded. Both became less of an issue after the Fed said it was contemplating an end to its bond-buying program.

Oil was swept up in the selloff. Crude oil had its biggest one-day price drop since November. U.S. benchmark oil for July delivery sank $2.84, or 2.9 percent, to finish at $95.40 a barrel in New York. Gasoline futures fell more than 3 percent.

Some investors said the sell-off in stocks may be overdone. The Fed is considering easing back on its stimulus because the economy is improving. The central bank has upgraded its outlook for unemployment and economic growth.

The S&P 500 is still up 11.3 percent, for the year, not far from its full-year increase of 13.4 percent last year.