More signs of weakness in the mortgage market, another surge in oil prices and a Federal Reserve rate decision could create more turbulence for Wall Street this week.
Widening fallout from the U.S. housing slump has rattled credit markets, putting investors on edge about the outlook for corporate takeovers and share buybacks -- two catalysts of the market's recent rally to record highs.
On Friday, Standard & Poor's cut its ratings outlook on the debt of investment bank Bear Stearns Cos.(BSC.N: Quote, Profile, Research), fanning concern that troubles in the subprime mortgage market are spreading, which could threaten the economy's health.
The rating agency's move came as American Home Mortgage Investment Corp., a subprime mortgage lender, announced plans to close most of its operations, joining a growing list of casualties hit by the stalled housing market.
The market is really struggling with defining the size of the subprime problem. The market does not like uncertainty, said Jim Fehrenbach, head of Nasdaq trading at Piper Jaffray, in Minneapolis.
Investors will tune in to what the Federal Reserve says in its assessment of the U.S. economy's outlook on Tuesday, when it releases its policy decision on interest rates.
The Federal Open Market Committee, the Fed's policy-setting body, is widely expected to keep rates unchanged, so investors will be focused on the central bank's assessment of risk, especially regarding troubles in the subprime market, and following the government's report on Friday that showed job growth is slowing. The FOMC statement is expected at about 2:15 p.m.
The Fed has held the fed funds rate for overnight bank loans steady at 5.25 percent since June 2006.
WHEN THE BEAR GROWLS
The toll from housing is hurting the financial sector, with the S&P financial index now down 12.7 percent year to date, as investors fret about likely losses tied to rising delinquencies on subprime mortgages.
There's more to come with the credit problems. You're going to get a ripple effect, said Alan Lancz, president of Alan B. Lancz & Associates Inc., an investment advisory firm, in Toledo, Ohio.
It's not just subprime. It affects a lot more -- anything from the economic numbers to investor psychology to the wealth effect as equity prices move down.
On Friday, credit worries escalated after more news about Bear Stearns' exposure to the subprime mortgage market, which sparked a sharp sell-off in stocks.
By Friday's closing bell, the Standard & Poor's 500 index and the Nasdaq had suffered their worst one-day percentage losses since the February 27 rout in global markets, which was triggered by a steep drop in China's benchmark stock index.
Bear Stearns' chief financial officer said bond market woes that are driving investors away from risk may be a worse problem than the 1987 stock market crash.
The Dow Jones industrial average sank 281.42 points, or 2.09 percent, to end on Friday at 13,181.91. The Standard & Poor's 500 Index slid 39.14 points, or 2.66 percent, to 1,433.06. The Nasdaq Composite Index tumbled 64.73 points, or 2.51 percent, to 2,511.25.
For the week, the Dow fell 0.7 percent, the S&P 500 declined 1.8 percent and the Nasdaq lost 2 percent.
Yet for the year so far, all three major U.S. stock indexes are still higher: The Dow is up 5.77 percent, the S&P 500 is up 1.04 percent and the Nasdaq is up 3.97 percent.
FEAR AND LOATHING ON WALL ST
In one sign of just how skittish investors have become, Wall Street's so-called fear gauge, the Chicago Board Options Exchange's Volatility Index, or VIX, is at a four-year high. It has stayed above a reading of 20 for seven straight trading sessions, reflecting the market's nervousness.
I absolutely think the volatility is here to stay, Fehrenbach said.
Andrew Wilkinson, senior market analyst at Interactive Brokers Group, in Greenwich, Connecticut, said of the past week's sell-off: We are finishing off with signs that financing for these (merger) deals could fall apart, leaving bankers holding the bag.
While investors appear to have paid scant attention to earnings as the subprime troubles dominate the headlines, next week's roster of companies set to report quarterly results will include utilities like Duke Energy Corp., PG&E Corp. and Edison International.
Tech bellwether Cisco Systems Inc., the world's largest maker of routers and switches that direct Internet traffic, and American International Group Inc. (AIG.N: Quote, Profile, Research), the world's largest insurer, also will post earnings.
Second-quarter earnings for companies that make up the S&P 500 index were projected to rise 6.8 percent, up from 6 percent in the previous forecast, according to Reuters Estimates.
It's earnings season, but I don't drive to work worrying about earnings headlines. I drive to work worrying about subprime and, is another home lender going to come out and say we're going out of business, Fehrenbach said.
Wall Street's string of worry beads includes the price of crude oil, which hit a NYMEX record high last week of $78.77 a barrel, adding to concerns about spending problems for the consumer. But by Friday's close, prices had retraced some of those gains, with the September crude oil contract settling at $75.48 a barrel, down $1.38 on the New York Mercantile Exchange.
NOW FOR A WORD FROM THE FED
Investors will watch for any encouraging words from the Fed on Tuesday afternoon. Besides the Fed's statement, the market will await a report that morning on second-quarter productivity and labor costs. The data on unit labor costs is closely watched by the Fed as an inflation measure.
The past week's big event -- the July nonfarm payrolls report -- was overtaken by deepening gloom about the mortgage market. Friday's economic data showed weaker-than-expected jobs growth and slower service-sector growth, which gave investors more cause for concern about the economy's health.
U.S. employers expanded their payrolls in July at the slowest pace since February, adding only 92,000 jobs, and the unemployment rate rose to 4.6 percent, its highest level since the start of the year, the Labor Department said.
After the July jobs report, U.S. interest-rate futures showed the implied chances of an October interest-rate cut from the Fed had climbed to almost 75 percent -- the highest in three months.
Other data in the coming week includes July import and export prices and the federal budget deficit estimate. Both are due on Friday.
Economists surveyed by Reuters have forecast that the federal budget deficit for July will be $32.5 billion, smaller than June's U.S. budget shortfall of $33.2 billion.
(Additional reporting by Ellis Mnyandu, Doris Frankel and Ros Krasny)