Stocks Tumble on Economic, Earnings Worries

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

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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.