Stocks: The Street's Fears Deepen

A dismal report on the services sector sparked big losses in major indexes Tuesday. Investors may be in for more pain in the days ahead

by David Bogoslaw

Fears of an imminent U.S. recession were palpable on Wall Street on Tuesday, as investors reacted with dismay to a report indicating the first contraction in the services sector in nearly five years. Major U.S. indexes plummeted, in some cases recording the biggest one-day declines in a year.

On Tuesday, the Dow Jones industrial average finished 370.03 points, or 2.93%, lower at 12,265.13. The broader S&P 500 index lost 44.18 points, or 3.20% to trade at 1,336.64, its biggest one-day loss in a year. The tech-heavy Nasdaq composite index fell 73.28 points, or 3.08%, to 2,309.57.

The selloff started from the opening bell, with the market primed by the release of the Institute for Supply Management's non-manufacturing report an hour earlier than the scheduled time due to concerns that the data had been leaked.

The non-manufacturing composite index plunged to 44.9 in January from 53.2 in December, much worse than the paltry dip to 53.0 that had been expected. The business index dropped to 41.9 in January from a revised 54.4 reading in December, while the unemployment index fell to 43.1 from 51.8 in December.

"This is a dire reading on nonmanufacturing activity that portrays the emergence of recession-like conditions in the economy," John Ryding, U.S. chief economist at Bear Stearns & Co. wrote in an email research note on Tuesday.

The data add to the decline in nonfarm payrolls in January and massive tightening in credit conditions for residential mortgages, commercial mortgages, and commercial and industrial loans reported on Monday by the Fed's Senior Loan Officer Survey, pointing more clearly to a recession, Ryding wrote.

In the past, the ISM's manufacturing report has been viewed as a good gauge of economic conditions. While the rebound in the manufacturing composite index above the critical 50 mark suggests slow growth in January rather than recession, recession risks continue to grow, Ryding said in his Bear Stearns note. If a recession materializes, the Federal Reserve's policy making arm, the FOMC, is likely to cut the Fed funds rate to 2% by the middle of the year, he said.

Given that the service sector has become the backbone of the U.S. economy, the ISM report suggests a psychological break before an actual recession during which "business owners and chief executives begin to think we’re seeing a slowdown and they slow down their hiring," said Quincy Krosby, chief investment strategist at The Hartford in Hartford, Conn. "If we start getting layoffs after layoffs, there’s no doubt" that a recession will have begun.

As for major stock indexes, "there has been an expectation, despite the tickup on Friday [Feb. 1], that we were going to be testing the bottom, and I’m hoping that’s what it is, a test of the bottom, and not a push down to go below that," said Krosby.

But she added that this is an integral part of the de-leveraging and re-pricing of risk that must take place in order to restore the credit markets to a healthy condition.

There are plenty of catalysts that could ignite follow-up rounds of furious selling in the days ahead, Krosby warned. They include any evidence, even anecdotal, that the prime credit-rated consumer is showing continued signs of weakness, and signs of a deepening quagmire for bond insurers, such as further ratings downgrades, she said.

If more uncertainty about the Presidential election emerges from the Super Tuesday primary results, that could also bode poorly for equities, Krosby said.

"It would be helpful if each party would be able to show a clear winner," she said. "The 'spam' calls [to voting households] by candidates are all about telling people how bad the economy is." The candidates' focus on the issue is contributing to perceptions of recession, she notes.

What could get the market moving back up again? Krosby thinks some sign of resolution or viable plan for the bond insurers would help, as that would remove a big concern from the market.

Richmond Federal Reserve President Jeffrey Lacker told banking leaders in Chartleston, W.Va., that "