Gloom, followed by doom; fresh four-year lows served up

Kevin Pendley | Oct 07, 2008 4:26pm EDT | Comment

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In a familiar refrain, small-cap stocks resumed the sell-off Tuesday, sinking to session lows in the afternoon following a somber economic outlook from the Federal Reserve chief that only served to remind investors that the problems facing the market aren’t going to go away anytime soon. The Russell 2000 (NYSE:IWM) collapsed 36.96, or 6.20% at 558.95, which marked the lowest daily close since September 2004 and the second-worst one-day decline of the year. The Russell is now down 27% for the year, and off 34.7% from the highs, while the Dow is down 28.7% for 2008 and the S&P 500 is off 32.1% for the year.

The day actually started out with promise, as a volatile pre-opening volley landed in a bullish corner when the Federal Reserve said that they would open a window for commercial paper loans, which would help corporations fund day-to-day operations. At one point shortly after the opening, small caps were up more than 1% from Monday’s close, but the buying interest quickly unraveled as financial stocks were sputtering and as the market clearly didn’t see the commercial paper facility as a panacea for all the current economic ails. In addition, the market is gorged on supply right now and without time to recover from the General Electric (NYSE:GE) issuance last week there comes word that Bank of America Corp. (NYSE:BAC) will raise $10 billion capital.

What’s more the outlook for profit growth is “glum” and investors aren’t eager to step in and buy until they see more earnings releases out of the way, Nick Kalivas, vice president of financial research with MF Global, said in an email. When BAC pre-released bad earnings news overnight, slashing dividends and raising capital, it left a bad taste in the entire financial arena. BAC shares shed 25% today, bank stocks lost 8% and the overall financial sector was also down some 8%

This afternoon, when Federal Reserve Chairman Ben Bernanke said that downside risks to the economy were “rising” it sparked a new wave of selling in equities even though the Fed chief also intimated that they were ready to cut rates again if needed; a concept granted more weight after the release of the FOMC minutes following the Bernanke comments.

“The recent intensification of the financial crisis has heightened the downside risks to the economy, as reinforced by Bernanke’s testimony this morning. While there are still worries inside the Committee about residual inflation, the FOMC’s clear tilt is toward lowering its target federal funds rate yet again,” Steven Wood, chief economist with Insight Economics, said via email. “While there is some speculation of an ‘emergency’ inter-meeting rate cut, we judge that unlikely, primarily because the current financial turmoil is not interest rate related and further rate cuts at this time would do little to resolve the illiquidity in the marketplace. Nevertheless, the next Fed policy change will be to lower interest rates, probably sooner rather than later,” Wood said.

It was interesting to see that Bernanke also made note of “extraordinary volatility” in the commodity markets. One could argue that dramatic moves in physical markets — and in commodity-themed stocks have clearly been at tidal wave force in recent weeks. Part of that story appears to be dramatic unwinding of short dollar/long commodity trades and also massive hedge fund liquidation of long commodity stocks amid a sea of redemption demands from investors. Looking at today’s action, commodities finally saw a little calm, with the Commodity Research Bureau Index up just 0.8%, crude oil up about $2 a barrel and the greenback off about 0.9% against the euro. Small-cap stocks were closely tracking movement in commodities in recent weeks, but were unable to find support on that theme today as sinking financial and industrial shares proved too large an obstacle.

Looking at broad market sectors today, investment banks, financial services shares, real estate investment trusts, automobile manufacturers, construction, homebuilding and office electronics were all getting trounced. Even the firmer tone in cash commodities wasn’t that big of a buffer for commodity stocks, with the Energy Select Sector SPDR Fund off about 4.5%. The ISE Homebuilders Index tumbled some 8.5% and the S&P Retail Index was off 5.5% -- if the economy and employment picture don’t improve soon, then safe sectors anywhere will be difficult to find.

One area of hope coming into today’s session came from the technical side of things. After all, the market was oversold on most momentum reading indicators and the big late rally Monday afternoon left a bullish formation on daily candlestick charts. However, once the Russell slipped back through 590 this morning it took all the starch out of the chart formation from Monday, and oversold momentum readings alone simply are not enough to suggest that a bottom is here. In a panic situation, the market can explode through oversold readings with abandon. Looking ahead to Wednesday’s action, the Russell is now below long-term support in the 570 zone, which corresponded with the major bottom from the spring of 2005. The next support area to watch is along the 560 line, down to 545.

It should be noted that when the market was forging that bottom three to four ago, it was within the context of a correction in a big bull market move. This time around, the market is sinking fast in a big bear market amid an economic recession. Three of the last four recessions since 1970 have seen the stock market retreat nearly 50% from the highs. As noted in the lead paragraph, the Russell is now 34% below the 2007 record high.