Time to Retest March Lows

Stocks will enter this data-heavy week in a tepid mood. The Dow fell 1.6% last week, its worst week since early July. The S&P fared even worse, down 2.2%. Both indexes managed to open in the black today, thanks mostly to surprise merger news from several sectors: Xerox is buying ACS, Abbott Labs is buying Solvay and Johnson & Johnson picked up a big piece of Crucell.

“Whether this correction in the market since last week turns into a more bearish scenario,” writes Dan Amoss, “will depend entirely on investors’ appetite for risk, which is very high. There’s not much fear out there today, as everyone seems convinced that the economy will be off to the races in a sustainable recovery at any point now. But markets that rise on speculative hopes rather than solid fundamentals tend to reverse violently. Fear of recent paper gains vanishing could overwhelm fund managers’ fear of missing a rally, which has been the primary explanation for this overstretched market to remain aloft.

“Many desperate managers have resorted to chasing ‘junk’ stocks or overvalued stocks like Research in Motion (RIMM). You can see how the bottom fell out of RIMM after this overvalued, over-loved security missed earnings expectations last night by just a smidge. We could see the same sort of reaction in stocks when they report earnings in the coming weeks…

“If I had to point to one factor that’s driven investors to bid up risky assets, it would be the dramatic compression in credit spreads from panic levels to levels that price in a typical postwar economic recovery. This compression in credit spreads — the rally in junk bonds and leveraged loans — has had a magnified influence on stocks that represent levered bets on credit risk and resumption of debt-fueled consumption: banks and real estate investment trusts.”

The Daily Reckoning