Stocks Tumble on Economic, Earnings Worries

Major indexes each dropped over 2% Wednesday, led by a slump in financial stocks

Major U.S. stock indexes tumbled Wednesday amid a late burst of selling. Ongoing worries about the economy and corporate profits curbed buying interest in the market.

The pullback more than erased a 152-point gain by the Dow industrials on Tuesday.

The weakness was led by financial issues, including Freddie Mac (FRE), Fannie Mae (FNM), Citigroup (C), and Merrill Lynch (MER), and tech issues such as Cisco Systems (CSCO) and Intel (INTC).

On Wednesday, the Dow Jones industrial average slumped 236.77 points, or 2.08%, to finish at 11,147.44. The broader S&P 500 declined 29.01 points, or 2.28%, to end at 1,244.68. The tech-heavy Nasdaq composite index dropped 59.55 points, or 2.6%, to close at 2,234.89.

Shares of Freddie (-23%) and Fannie (-13%) dropped sharply again on Wednesday on fears the government-sponsored enterprises (GSEs) will need to raise capital by selling billions of dollars worth of stock, according to S&P MarketScope. The aggressive selling began after Fannie Mae priced a new $3.0 billion issue of two-year benchmark notes at a yield of 3.272%, marginally higher than the coupon of 3.25%, sparking fear about the difficulty the GSEs may have in raising capital as long as the housing market shows no sign of stabilizing. That helped push shares of Fannie down 13.1% and Freddie shares down 23.8%.

While the disparity between the coupon and the yield at which the bonds priced amounts to just a few basis points, what scared everyone is that the bond is so short-dated, says Bill Larkin, portfolio manager of fixed income at Cabot Money Management in Salem, Mass. He called the selloff in the stocks "an overreaction caused by [the fact that] we’re starting to drift apart from the pure agencies like the Federal Home Loan Bank and Farm Loan Credit bonds," since global issues like Fannie's are very liquid and tend to trade in line with the benchmark.

Just minutes after the 4 p.m. market close on Wednesday the notes were trading at a yield of 3.12%, showing they appreciated over the course of the day, which was positive, he says.

"It’s not really worth worrying about at this stage,” says Larkin. "If they started having trouble with longer dated securities and spread widened, that would set off alarm bells."

When pushing through a deal as big as $3 billion in the current environment with so many investors sitting on the fence, it shouldn't be surprising to see market distortions such as a disparity between the benchmark and actual yields, Larkin says.

"Anyone who does research on Fannie and Freddie knows they’re a vital part of the banking system," he says. "They're too big to fail and too important right now because they’re building liquidity in a marketplace that didn’t have liquidity."

At the start of the day, the dollar fell against the yen, euro and Swiss franc in response to Iran's announcement that it test-fired a long-range missile capable of reaching Israel. The news also pushed crude prices higher, helping them bounce after a two-day selloff. More pressure on the dollar resulted from Fitch Ratings putting Merrill Lynch on negative credit watch for an imminent downgrade, citing worries about further portfolio writedowns and debt due to mature within the next year.

Investors' reluctance to step in to buy beaten-down stocks didn't surprise Quincy Krosby, chief investment strategist at The Hartford in Hartford, Conn., with earnings season barely having begun. "Why race in until you've heard from the likes of General Electric (GE), a true bellwether company with operations in every part of the world" or key technology manufacturers about how their overseas order flow is looking, she says.

GE is scheduled to report quarterly earnings before the start of trading Friday.

Although the market is trying to put in a bottom, mounting fears about how Iran's missile test and other sources of geopolitical tension will affect oil prices are postponing investors' readiness to start adding to their equities positions again, says Peter Cardillo, chief market economist at Avalon Partners in New York.

Crude supplies, already below five-year averages, fell by another 5.84 million barrels in the week ended July 4, the Energy Information Administration said on Wednesday. The drop was much bigger than the 1.4 million barrel decline that Dow Jones had estimated. Gasoline inventories rose by a larger-than-expected 900,000 barrels a day and distillate supplies were up by 1.8 million barrels a day. The data will probably support higher oil prices, analysts say.

August WTI crude oil futures traded higher for most of the day before sinking back to settle just two cents up at $136.05 a barrel on Wednesday.

New economic reports are on hold until Friday, but the U.S. Mortgage Bankers Association said its Market Composite Index, which measures mortgage application volume, rose 7.5% on a seasonally adjusted basis during the week ended July 4. Excluding an adjustment to account for the Independence Day holiday, the Index dropped 14.1% from the prior week and 18.1% from a year ago. The Refinance Index climbed 8.7%, while the seasonally adjusted Purchase Index increased 6.7% from the previous week.

Among other stocks in the news on Wednesday, Alcoa Inc. (AA) shares at first got a lift after the aluminum giant beat analysts' second-quarter earnings estimates by 17 cents a share, but ended the day lower as the market focused on the 24% drop in its GAAP earnings to 66 cents from 81 cents a share a year ago on a 5.6% decline in sales. The company noted that, while the latest results were down from last year, its profitability rose compared with the first quarter, as higher volume and stronger pricing offset higher input costs that hurt the entire aluminum industry. Standard & Poor's reiterated its buy rating and Friedman Billings Ramsey upgraded the stock to outperform.

Shares of Cleveland-Cliffs Inc. (CLF) soared after the company raised its outlook for iron ore revenue from its Asia-Pacific segment to $102 per ton and its North American segment to $85 per short ton for 2008. The mining company noted recent iron ore pricing settlements in Australia of an 80% increase for fines and a 97% increase for lump sum, and now expects a roughly 34% increase in adjustment factors related to steel pricing, based on an annual average hot band steel price of $750 per ton at certain customers' steelmaking facilities.

CIRCOR International (CIR) shares surged after the manufacturer of valves and fluid control products raised its second-quarter earnings outlook to $1.04 to $1.10 a share from an earlier forecast of 74 to 83 cents, citing strong results in its Instrumentation & Thermal Fluid Controls segment.

Arris Group (ARRS) shares fell after the company said it sees lower-than-expected revenue of $278 million to $280 million in the second quarter due to maturing demand for EMTAs as well as for plant extension and installation equipment. The broadband software provider also said its earnings will be at or near the lower end of its previous guidance, but booked orders and backlog will improve compared with the prior quarter. S&P maintained its buy rating.

Major European indexes were trading higher Wednesday. In London, the FTSE 100 index gained 1.64% to trade at 5,529.60. In Paris, the CAC 40 climbed 1.50% to 4,339.66, while Germany's DAX index rose 1.30% to 6,386.46.

In Asia, Japan's Nikkei 225 closed 0.15% higher at 13,052.13, and Hong Kong's Hang Seng index advanced 2.76% to end at 21,805.81.

Treasury market

Treasuries rallied on the rout in equities. The 10-year note moved up 18/32 to 100-16/32 for a yield of 3.81%, and the 30-year note rose 17/32 to 99-08/32 for a yield of 4.42%.

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