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Stocks: Making Sense of November's Slide

What could stop the bleeding? One pro suggests a "shock and awe" Fed rate cut of a full percentage point

The subprime problem has been on investors' minds since the summer, when losses on risky mortgages froze part of the credit markets and sent stocks plunging.

By early fall, "People really thought the problem was well on its way to being healed," says John Merrill of Tanglewood Capital Management in Houston.

Then, he says, "round two" hit.

For the last three weeks, major stock indexes have sunk even lower. The broad Standard & Poor's 500-stock index is now down almost 6% for the month, nearly wiping out all gains for the year. It's not just financial stocks feeling the pain: The tech-heavy Nasdaq, which had previously reflected technology's surge in recent months, is down about 8% in November.

Seeking Good News

News of large losses at big financial institutions such as Merrill Lynch (MER) and Citigroup (C) started the drop, but since those headlines appeared, the market's gloomy mood has only deepened.

For one thing, conditions in credit markets only got worse, meaning that huge losses on credit derivatives reported in October are now likely even bigger.

Investors are so worried about risky assets that they're pouring money into safe U.S. Treasuries; so much money that two-year notes now earn a yield of just about 3%, barely enough to keep pace with inflation.

"There's a lot of fear out there," says Peter Cardillo, chief market economist at Avalon Partners. The fear level is so high that at some point the market inevitably will realize "the end of the world isn't here," he says.

The problem: A switch in market sentiment will need some news as a catalyst. "For the moment, I don't see any new catalysts that would do that," Cardillo says.

Consumers? Anyone?

Hopes have been dashed for a quick mop-up of the subprime mess. "What's been particularly discouraging is we never were able to quantify the subprime situation," says Georges Yared of Yared Investment Research.

Now, he says, the bad news will continue to trickle in, probably into 2008.

So what might end the stock market slide? There are a few things that could brighten investors' moods, though none are a sure thing.

First, holiday shoppers could help out Wall Street—if they open up their wallets.

Richard Sparks of Schaeffer's Investment Research says "the early returns" from the Christmas shopping season, if positive, "may give the markets a reason to breathe a sigh of relief."

But this all-important time for retailers could be in danger due to consumers' worries about falling home prices or rising food and energy prices, he says.

Earnings Mixed, Economy Uncertain

A second catalyst could be corporate earnings. "What's holding the economy up is the strength of exports and the strength of technology sales," Yared says.

The third quarter has offered investors the weakest corporate earnings in five years. Financial, energy, and cyclical consumer stocks all posted double-digit year-over-year declines. But, according to Reuters Estimates (RTRSY), 65% of companies in the S&P 500 have beaten analysts' estimates, with tech stocks showing the most strength. If sectors such as technology, industrials, and health care can post big profits in future quarters despite the economic uncertainty, they might help outweigh falling earnings in other sectors.

Another catalyst could be good news on the economy. "The economic data to date continue to show scant evidence of a spillover of problems in the financial and housing markets into the real economy," writes Bear Stearns (BSC) Chief U.S. Economist John Ryding.

Many economists say while the economy appears to be slowing down, a recession is still unlikely. The market seems to be betting on a much higher chance of recession.

Of course, if any signs of trouble do appear—particularly pain in the labor market—market conditions could go from bad to worse quickly.

Depending on the Fed

Finally, the Federal Reserve or other policymakers could take drastic action to, in Ryding's words, "unclog the plumbing of the financial system."

Though the Fed has sent mixed signals, the Fed funds futures market is now betting the Fed will cut rates by at least a quarter-point at its Dec. 11 meeting. Some would like the Fed to do much more. A larger cut could help subprime mortgage holders refinance their loans and provide a "huge shot in the arm" to the housing market, Yared says. Ryding favors a "shock-and-awe cut" of a whole percentage point. Other policies from the federal government could bring more money into the mortgage market, he says.

The biggest problem for the market is that so much is riding on the Fed and its response to the subprime crisis. With so much attention on subprime problems, usually important factors such as consumer sentiment, corporate earnings, and economic data seem to be taking a backseat. "It's been credit problems 24/7," Sparks says.

And there's no sign the bad news about subprime is letting up any time soon. For long-term investors, the market's November lows may be an opportunity. But short-term investors might want to take an extra long holiday vacation.

Steverman is a reporter for BusinessWeek's Investing channel.

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