Spooky Treasury auction, financials spark small-cap slide

Small-cap stocks reversed course Tuesday, unable to sustain upward momentum from Monday’s surge as weakness in financial and homebuilder stocks and numbing results from the Treasury four-week bill auction overwhelmed support from energy and a surprising upside midday spurt on tech stocks. The Russell 2000 (NYSE:IWM) closed down 15.67, or 3.25%, at 465.71 and is now down 39% for 2008. For the year, the Dow is now down 34%, while the S&P 500 is down 39%.

It appeared that the afternoon trigger point for the sudden influx of selling in equities was tied to the results for the Treasury four-week bills, which not only came in at 0.000% (yes, zero), but saw a bid-to-cover ratio of 4.20. In addition, the three-month T-bill traded with a negative yield at times today. The yield on the long bond is nearing 3% once again, which is basically unheard of, and yields for both bonds and benchmark 10-year notes fell hard today as demand ramped up for Treasury products (which tug money flow away from stocks).

“These events in the Treasury market are causing traders to believe that the market lacks liquidity or buying power,” Nick Kalivas, vice president of financial research with MF Global, said in an email interview. “Institutions like hedge funds, fund of funds, etc. have to stash money in a T-bill for reasons of risk management – like expected redemptions and this is robbing the market of buying power and generating fear,” he said.

Kalivas said it will be important to see how demand goes for three-year and 10-year note auctions, as weaker results could boost equities by suggesting that the demand for liquidity is more short-term than long-term in nature. “It is one thing to buy up a three-month T-bill, but an aggressive bid on a 10-year note auction would signal long-term pessimism toward the economy and rob stocks of buyers,” he said.

Interestingly, technology stocks consistently outperformed other index products today, even though the session started out with gloomy news on the tech front from Texas Instruments Inc. (NYSE:TXN), which cautioned about the outlook and from Japan’s Sony, which announced massive layoffs numbering some 16,000 . . .

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