I’m assuming that you know “how” the market works, i.e. brokers set the price of stocks depending on whether there is a majority of sellers (price falls) or buyers (price rises). If this is a mystery, try The Motley Fool, http://www.fool.com.
WRT the state of the market at present: think of it as like, say, a large fish tank that’s been given a good hard shake. It looks pretty turbulent at the moment, but it’ll settle down eventually 
With all respect to China Guy’s Star Trek analogy, maybe thinking about rare paintings would be easier for you, koufax.
Why is Monet’s “Water Liliies” worth umpteen gajillion dollars? You can’t live in it. You can’t eat it, or wear it. Presumably you’d get some value from it if it were hanging on your wall… but umpteen gajillion dollars worth of value?
Probably not. Why, then, are people willing to pay so much for rare paintings?
One way to look at it is that I pay so much for it because I believe that others will pay even more, later on. So if I buy a painting for $1 million and hang on to it for a year, I think I can sell it for $2 million. I’m not worried about the fact that the painting has little intrinsic value – I know that the world will still consider rare paintings worth buying in a year.
Stocks are similar. Stocks have a certain intrinsic value: you own a percentage of a company when you own its stocks. If that company makes a profit, it may pay you dividends. Keeping the stocks means you keep the dividends - some of the profit - the company made.
But stocks are often priced far higher than they would be if people wre just buying them for dividends, just like the paintings are priced far higher than the mere value they give for being hung on the living room wall. This is the speculative value: we buy them believing that someone else will buy them for more money, later on.
How can I make money, then, if a stock is going down? Well, I could sell you the stock at today’s prices… even though I don’t own the stock. I do that by borrowing the stock, and agreeing to “pay back” the borrowed stock later on.
If the price of the stock has dropped later on, I can buy it at the lower price, pay back the guy that lent it to me, and I’ve made money! Of course, if the stock rises, I’m screwed: I still have to buy it to pay back the guy that lentme the stock, and now I’m paying more to replace the stock than I sold it for.
koufax, when you suggest that traders don’t create anything, you’re missing the point. It’s true that they don’t make furniture, or cars, or guns. But neither does a retail store. A retail store merely brings other people’s products to you, under one roof, and lets you buy them. They provide a valuable service.
So, too, does the market. Speculation in the performance of stocks and other instruments is a necessary and profitable part of the economy. Sometimes the ecocomy is doing so well that most business flourish, which means that no matter what stocks you buy, you have an excellent chance of selling them at a profit. Sometimes the economy tanks, which means that business don’t earn as much, and people begin to believe that they can’t sell their stocks at a profit.
But it’s not magic, or BS. It’s the market.
another reason people dump stocks is so they can buy some other ones that are doing better. Like cable tv, cell phones, defense stocks are doing better these days. People are staying home & watching tv 
Let’s also remember that (some) stocks pay dividends. As a part owner of a company, you’re entitled to a portion of the profits. Back in the days before deregulation, telephone companies and utilities were allowed by regulators to make steady, if unspectacular profits. Every three months their stockholders would get a check equal to a nickel a share or something similar. Those stocks were called “widow and orphan” stocks becuase of their dependability.
These days, more of the value of a stock is found in its potential for growth, but some companies still issue dividends. If the company doesn’t turn a profit, no dividend. And that’s why people dump that category of stock.
A little off topic, but I was astounded by a line in this morning’s Wall Street Journal. Talking about airport security, David Wessel wrote
“The market, so justly celebrated since the collapse of communism, isn’t good at everything. Unfettered markets are terrific at getting business to give consumers what they want. . .markets don’t always give us what we need, particularly things that benefit all but turn a profit for no one in particular.”
I’d like to add one additional point to what Bricker and China Guy said.
koufax seems to think that buying and selling shares is pointless after an IPO or any other offering made by a company because the cash doesn’t go to the company itself. What he is missing is the fact that the secondary market is necessary for IPOs to work. Put simply, if an investor could not readily sell his shares on the open market, there is a huge disincentive to invest in the IPO in the first place.
An example: say XYZ Corp. decides to go public to raise money to build a plant. It plans an IPO. XYZ now has to convince the investing community that buying shares in XYZ is a good idea. The best way for it to do that is to say “XYZ is poised for strong growth and down the road many other investors will want to buy these shares for much more money than we’re offering them for now.” In order for that pitch to work, there has to be an active market of buyers and sellers where the initial investors can sell their shares and take a profit at a later date.
“More questions. Why WAS Amazon valued so high?”
Search for ‘amazon’ here, this has been answered a lot.
On the news today, they said that put options were bought 11 times more than usual for airlines just before the attack. They want to go through the paperwork to see who bought them, then they know who did the attack supposely. Cool.
Also, this topic is getting to be a lot like this one:
http://boards.straightdope.com/sdmb/showthread.php?threadid=88323
How the hell can you “borrow” stock? Then sell it?
Sell something that you don’t own?
This is what I am talking about. It seems this whole market things has rules that are made up by people to make ( and lose) more money and don’t really just reflect a company’s profitability which is how it should be.
How do I borrow some stock? If I borrowed someones car and sold it, I could be arrested.
Thanks to all who have tried to explain this, but I am getting the feeling that most people don’t really understand this whole thing.
I remember when Magic Johnson announced he was HIV positive and then said he had called Jerry Buss, the Lakers owner and told him the bad news. I thought (and you can see how much I understand) Buss and Johnson and others could buy stock in pharmeceutical companies before this was announced to the public. And then guess what? I heard that these stocks went up in value after the announcement. So did Buss and Magic and others profit from this news? I have a feeling that they did. I know it is illegal but there are ways. Like I said, if I thought of it, they MUST have thought of it also.
Actually, if you stole someone’s car and sold it you could be arrested. If you borrowed it, with the consent of the owner, with the understanding that you would get the car (or another one just like it) back in the owners hands at a later date, then there’s nothing wrong or unusual about the transaction.
That’s what happens when someone sells short. He borrows shares from an existing owner with the understanding he will replace those shares at a later date.
And, in fact, the possibility of selling short improves the ability of a stock’s price to reflect the company’s profitability. If a company’s profitability is going downhill, then the value of owning that company is also going down. The only way the stock price will reflect that downturn is if sellers outnumber buyers, thus driving the price of the stock down. Thus, selling short allows more investors to communicate price information to the markets – you don’t actually have to own shares to communicate negative inferences about a company’s prospects.
If it helps you, think of buying stock on margin. When buying on margin, a buyer basically borrows the money to purchase shares. It is understood that the funds will be repaid at a later time. Selling short is like buying on margin, but in the opposite direction: instead of borrowing cash to purchase shares, you borrow shares to “purchase” cash.
It should be obvious NOW why you dump stocks at the first sign of big bad news. Because shareholders tend to panic and over react. Anyone that sold the US index on the first day is a lot better off now than if they held on to their stock.
Of course, if you are a long term investor, you have to sell and then pick the correct time to buy back.
Another way to look at it. If a stock drops in half or 50%, for example from $100/share to $50/share, then it has to double to get back to $100/share. Dot.com bubble aside, stocks usually take a long time to double. Just compare how much the Dow dropped last week, and how long it will eventually take to regain the level of 10 September.