A Sharp Reversal for Stocks

Nervous times continue on Wall Street, with indexes plunging over 2% only one day after Tuesday's Fed-inspired rally

Easy come, easy go. One day after the Dow industrials soared 420 points on a jumbo interest-rate cut by the Federal Reserve, investors had some second thoughts about the rally. Major U.S. equity indexes, pummeled by a late-session wave of selling, each sank over 2% on Wednesday.

On Wednesday, the Dow Jones industrial average tumbled 293 points, or 2.36%, to finish at 12,099.66. The S&P 500 index dropped 32.32 points, or 2.43%, to end the session at 1,298.42. The Nasdaq composite index finished lower by 58.30 points, or 2.57%, at 2,209.96.

Trading measures in the broader market were negative. On the New York Stock Exchange, 22 issues declined in price for every 9 that rose. The ratio of decliners to advancers on the Nasdaq was 20-8. Volatility in the S.&P. 500 reached a 70-year high, according to Howard Silverblatt, an analyst at Standard & Poor’s.

What happened? Ahead of Thursday’s Quadruple Witching – Wall Street-speak for the quarterly expiration of option contracts and futures contracts, and single-stock futures, frequently characterized by heavy market volatility – investors decided to take some profits off the table on Wednesday, according to S&P MarketScope.

Investors, still unnerved by the credit crisis, found fresh reason to worry after news hit that a unit of Merrill Lynch (MER) was suing XL Capital, a unit of bond insurer Security Capital Assurance, alleging the company is attempting to avoid its financial obligations of up to $3.1 billion under seven credit default swaps. Merrill shares sank 11% Wednesday, helping drag the S&P Investment Banking & Brokerage index down 4.68%.

Positive profit reports and news that there's more relief coming to government-sponsored U.S. mortgage companies, which could provide the liquidity needed to start thawing the credit markets, were trumped by the market’s continued jitters about the effects of the credit crunch. A successful IPO from credit-card titan Visa also failed to inspire the broader market.

Bonds prices rose as the Fed left the door open for an April rate cut. The dollar index gained. Oil and mining stocks skidded as energy and precious metals futures plunged following Tuesday's FOMC rate cuts and policymakers’ comments on inflation risks.

Thursday's reports on initial jobless claims, the Philadelphia Fed index, and leading indicators could add fuel to the debate over whether the economy has bottomed or the downturn is worsening, says S&P MarketScope..

“The lack of follow-through buying [on Wednesday] is disappointing for near-term bulls,” says S&P technical analyst Chris Burba.

Richard Sparks of Schaeffer’s Investment Research said there were rumors that Merrill might be preparing to take more subprime-related writedowns. But there might be a simpler reason for the stock market’s late-day sell-off on Wednesday: After Tuesday’s big rally, investors got nervous stocks were getting ahead of themselves.

“One of the things we’ve seen in the market over the last few weeks has been a propensity to sell off any rally,” Sparks says. With so many worries about the economy and credit and housing markets, he said, “The path of least resistance has been down.”

Georges Yared, of Yared Investment Research agreed, saying the murky environment might have encouraged investors to take profits from Tuesday’s rally. “It might be as simple as that,” he says. Investors realize they still must wait for more clues on the direction of the economy, and first quarter earnings reports don’t arrive until mid-April, Yared says.

Although the Fed shorted Wall Street by a quarter-point on Tuesday by cutting the benchmark Federal funds target rate only 75 basis points to 2.25% instead of the full percentage point that was expected, some say the Fed's action the was best outcome for the economy and financial markets in the immediate period ahead, according to S&P MarketScope. Not only did the central bank leave the door open for further monetary easing in April, but by showing some concern about the inflation risk, the Fed also provided a boost to the U.S. dollar index.