Sharp slide for small caps on soft data, financial woes

Small-cap stocks fell hard Tuesday, as the combination of credit worries, high inflation and a slumping housing market whipped up the perfect bearish storm. The Russell 2000 (NYSE:IWM) closed down 11.94, or 1.61%, at 730.03, while the Dow was off 1.14% and the S&P 500 was down 0.93%. For the year, the Russell is now down 4.69%, backing off quickly after flirting with a test of positive yearly territory late last week. The Dow is down 14.4% for 2008 and the S&P 500 is off 13.7%.

Financial shares remained at the center of the seller hurricane, extending the rout that started Monday as talk of more debt write-downs started making the rounds. The fresh target today was Lehman Brothers Holdings Inc. (NYSE:LEH), which crashed 13% after analysts predicted $4 billion more in bad mortgage debt was ready to rolled off the books this quarter. The shudder of renewed bad debt fear swept through financial stocks, with the Financial Select Sector SPDR Fund tumbling 2.9% and the PHLX KBW Banking Index sinking 3.4% Major U.S. banks like Citigroup Inc. (NYSE:C) and Bank of America Corp. (NYSE:BAC) were hit by the concerns, slipping 2.5% and 4.1%, respectively.

And while the credit crisis was back in play again today, the market also had to come to grips with yet another bad inflation economic report. Last week saw investors essentially shrug off scary inflation numbers on the Consumer Price Index release, dismissing the data as less disturbing because it didn’t reflect the recent collapse in crude oil prices. Then today’s Producer Price Index (PPI) report not only showed headline inflation at 27 year highs, but also reflected “core” inflation, which excludes food and energy prices, at 17-year highs. The realization that the inflation story isn’t just about $4-a-gallon gasoline pump prices and higher grocery bills is a sobering thought for the market.

Just to finish off the bearish news, July housing starts came in below the forecast, with the unit rate at the lowest point since 1991. So, PPI is at 27-year highs, core inflation is at 17-year highs and housing starts are at 17-year lows. Combined, it’s not a pretty picture, and it also handcuffs monetary policy makers who have to walk a tightrope between battling inflation versus coddling economic health.

Broad market sectors on the decline Tuesday included motorcycle manufacturers, real estate management firms, department stores, consumer finance, casinos, . . .

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