Stock Markets Face More Credit-crunch Volatility

NEW YORK (MarketWatch) -- U.S. stocks will fall next week, continuing a broad sell-off seen on Friday, as investors stay on high-alert for more bad news linked to dodgy home loans, credit woes, and their potential impact on the broad economy, analysts said.

"My expectations are that equities are in for another volatile week," said Mike Malone, trading analyst at Cowen & Co. "It's going to be difficult for equities to sustain any gains until the concerns in the credit markets begin to wane."

Investors will also anxiously await the meeting of the Federal Reserve on Tuesday to see whether central bankers signal growing concerns about credit markets.

Friday sell-off

Stocks again sold off on Friday, and finished the week sharply lower, after a weak July jobs report and news that Standard & Poor's downgraded Bear Stearns' credit outlook to negative, citing the impact of bad home loans on some of its funds.

The Dow Jones Industrial Average plunged 281 points, or 2%, to finish Friday at 13,181. The move left the blue-chip average down 0.7% on the week.

But most of the pain was seen in the broad market, which is heavily influenced by financial shares. The S&P 500 index plunged 39 points, or 2.7%, to 1,433 on Friday, for weekly loss of 1.8%. The Nasdaq Composite slid 64 points, or 2.5%, Friday to finish the week 1.9% lower.

This was the second week in a row that markets posted steep losses, as investors have become engulfed by fear about the availability of credit.

Bad U.S. home loans have turned into hefty losses for a number of hedge funds and banks around the world, while it has become much harder to raise money to finance leveraged buy-outs and share buybacks.

"We can expect ongoing tape bombs from various companies having various credit market problems," said Mike Englund, chief economist at Action Economics.

Besides Bear Stearns, which dipped 6.3% on Friday, brokers such as Goldman Sachs , Lehman Brothers , and Merrill Lynch , along with many mortgage lenders and banks, have fallen steeply and are expected to continue to weigh heavily on the market.

In addition, "there's still a lot of questions about who's still trying to raise debt to boost dividends and finance share buybacks," said Paul Nolte, director of investments at Hinsdale Associates. "Home Depot is still having problems placing its debt [for its share buyback]."

Fed to the rescue?

The Fed is widely expected to leave interest rates unchanged on Tuesday but its statement will be parsed for any clues central bankers are either edging closer to cutting interest rates, or would consider some type of intervention to prevent a credit crunch.

"Investors will certainly be looking to see what they have to say about the conditions in the credit markets," Cowen's Malone said. "But it's not certain what effect that will have on markets, even in the event that they do address those concerns."

In several speeches recently, Fed officials have indicated that they would not intervene to calm credit markets.

Ever since the Fed organized the 1998 bail-out of Long-Term Capital Management (LTCM), a hedge fund that failed after making the wrong bets before the Russian debt crisis, investors have come to rely on the U.S. central bank's willingness to intervene in times of crises. This reliance on the Fed has been dubbed the "Greenspan put", a reference to then-Fed-Chief Alan Greenspan.

But new Fed Chairman Ben Bernanke still has to earn his inflation-fighting credentials, "and might hold off longer before either signaling any rate cuts or some kind of intervention," said Ben Pace, chief investment officer at Deutsche Bank Private Wealth Management.

Earnings

Even as 33 companies from the S&P 500 report earnings next week, the reports will continue to take a back seat to credit concerns, as they have since the start of the second-quarter reporting seson.

Some investors will still find time to pay attention to earnings from tech-bellwether Cisco Systems on Tuesday and Dow-component American International Group Inc. on Wednesday.

Out of all the S&P 500 companies, 408 have so far reported earnings, most of which, or 66% have beat estimates. The year-on-year earnings growth rate has risen to 7% in the past week, up from 5.8% the previous week, helped by better-than-expected results from the likes of General Motors and Metlife . On July 1, expectations were for earnings growth of 4.1%.

But "if you look back at all the positive things that have taken place over the past couple of years in the market, whether its private-equity, share buy-backs and earnings, you can trace them to an easy money environment," said Cowen's Malone. "So what companies are reporting right now is less relevant."

One relevant development, meanwhile, is that a much smaller number of S&P 500 companies have been issuing forward earnings guidance during the second quarter so far, according to Thomson Financial.

The trend reflects growing uncertainty about the near-term future, according to Malone.

R-word returns

Some market strategists and economists are again suggesting that the slumping housing market, and now a possible credit crunch, have the potential to severely impact the U.S. economy, and even possibly tip it into recession.

Earlier this week, David Bianco, chief U.S. strategist at UBS, said that the S&P 500 is now pricing a recession starting in late 2007 and lasting through most of 2008.

The market suggests this would be mostly a "financial sector recession", Bianco said, adding that he said this scenario is "possible, but far from likely."

"We believe the market expects this recession to slash S&P 500 [earnings per share] by about 10%," Bianco wrote in a note. This, he said, is "not as bad as the 10-15% declines during the 1974-1975 and 1990-1991 low-inflation recessions, perhaps acknowledging [the exposure of S&P 500 companies to global growth]."

Economic data

Global growth and liquidity are often cited as factors helping U.S. multinationals overcome domestic economic and credit woes.

Investors might therefore pay some attention to June wholesale trade figures to be released on Wednesday.

On Tuesday, the same day the Fed meets, the market will also receive key data on second-quarter productivity and labor costs, both important gauges of inflation and growth, as well as June consumer credit data.

By Nick Godt