Red close as financial wounds not healed by GSE tourniquet

Kevin Pendley | Jul 14, 2008 4:29pm EDT | Comment

Rating: Unrated [rate it]

Small-cap stocks endured another sizable decline Monday, pulled down by tension over the health of the financial arena at a time when the economy is already struggling with rising unemployment, slumping housing markets and soaring energy costs. The Russell 2000 (NYSE:IWM) shed 10.45, or 1.55%, to 664.50, the third lowest daily close since mid-March.

The closing slide in small caps was a stark difference from this morning as the market appeared poised to begin the week with a relief rally. Stock index futures jumped some 1.6% during overnight action as investors embraced a plan by government authorities to shore up the balance sheet — and market confidence — in government-sponsored mortgage giants Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE). However, that overnight rally failed to gain traction relatively quickly once the market opened today, and a wave of selling swept through banking stocks, especially within the regional banking sector and smaller banks, which took a toll on small-cap index products. Despite opening up amid 20%-plus gains this morning, FNM and FRE eventually closed down 4.2% and 5.8%, respectively.

Elsewhere on the banking front, National City Corp. (NYSE:NCC) plunged 17% after trading was halted briefly on concerns about unusual trading activity. NCC was downgraded by analysts, and the stock dropped anchor, as the unsettling tide of selling coursed through financials a day after IndyMac Bancorp Inc. (NYSE:IMB) failed, becoming the third-largest U.S. bank failure on record.

There was some sense that investors are beginning to fret about all the special bail-out programs needed to avert systemic risk on the financial landscape. After all, there are only so many rabbits that magicians at the Federal Reserve and Treasury Department can pull out of their hats. What’s more, there are some concerns that these recovery efforts could flood the debt market with so much paper that supply issues could hamper funding, or even that the world could balk at “being the buyer of last resort for U.S. government debt,” as noted in a research report by economists with Northern Trust.

Although M&A activity tends to bolster bullish psychology, the announcement of a deal between Anheuser-Busch Co. (NYSE:BUD) and Belgian brewer InBev NV for approximately $52 billion had very little overall impact on the market, probably because the deal has been talked about for several weeks already. The finalization of an agreement between the two brewers failed to offer up enough of a surprise to overcome the fretting about financial market weakness. BUD finished out the session with a meager gain of 0.4%.

In a rare change of pace, price action within the energy markets was not a focal point for traders on Monday. Crude oil futures edged modestly higher amid concerns about a strike in Brazil, tension in Nigeria and ongoing saber rattling in the Middle East between Iran and Israel. The U.S. dollar was unable to sustain overnight gains tied to the initial euphoric response to the GSE bail-out news and remains in the lower portion of historic values against the euro. Elsewhere on the commodities front, although gold was up today, corn prices took a dive and have now lost 22% in two weeks amid better weather in the Midwest.

Broad market sectors on the slide today were highlighted by thrifts and mortgage finance firms. Also on the decline were regional banks, diversified banks, diverse financial services firms, investment banks and brokerage stocks. On the upside, apparel retail, metals and mining, coal and construction materials stocks attracted buyers. Despite the relatively tame day in energy markets, airlines shares struggled, with the AMEX Airline Index down about 2.5%. Small-cap stock US Airways (NYSE:LCC) tumbled about 11%.

Individual small caps on the move included Anaren Inc. (Nasdaq:ANEN), which dropped some 15% to fresh 52-week lows on earnings-related news. Maguire Properties Inc. (NYSE:MPG) lost about 15%, also tumbling to 52-week lows in the process. On the upside, Qiao Xing Univesal Telephone Inc. (Nasdaq:XING) jumped 28%, gapping higher on sales figures, but the move did come in the wake of sinking to fresh lows last week.

Looking ahead to Tuesday’s session, the market could face a tumultuous start of the day. Investors will get a chance to respond to key inflation news on the Producer Price Index and also on critical consumer spending patterns from the Retail Sales report at 8:30 a.m. ET. As if that weren’t enough, manufacturing information from the NY Manufacturing Survey also comes out before the regular open, and then Federal Reserve Chairman Ben Bernanke is slated to testify before the Senate at 10:00 a.m. ET on the economy and monetary policy, in which appears to be a very eventful morning.

Looking at the chart picture, the market appears to be establishing a consolidation zone in the Russell 2000 with the lows just above the March bottom and the highs around the 684 level. This type of volatile activity within a wide range was also seen at the January and March lows. A breakout in either direction of the consolidation area carries a target move of 32 handles, and is worth watching as we move through all Tuesday’s big news events.