Stocks After Lehman

Selling could continue tomorrow.

By + More

Investors watched their portfolios shrink in the aftershocks of today's wrenching news out of the banking sector. The collapse of Lehman Bros., Bank of America's surprise buyout of Merrill Lynch, and further uncertainty surrounding American International Group, America's largest insurer, has Wall Street seeing nothing but red.

Analysts say today's damage could have been much worse, but late-day weakness could mean more selling to come tomorrow.

Equity indexes fell through July lows following the latest in a seemingly endless string of problems issuing from the banking sector beset by ongoing woes in the housing and credit markets.

The S&P fell below July 15 lows of 1200, losing 4.6 percent to close at 1193, breaching a technical barrier that could set stocks up to set a new low. The Dow fell more than 500 points, or 4.4 percent, for the sixth-largest drop ever, with the index falling below the 11,000 mark in the final minutes of trading.

"If we end up near the lows of the day, it's more negative for the markets," said Justin Walters, an analyst at Bespoke Investment Group.

Further out, Nouriel Roubini, the bearish NYU economist and head of RGE Monitor who predicted last year the current problems in the banking sector, said today that stocks could fall further and that institutions like Goldman Sachs and Morgan Stanley could face Lehman-like problems.

A couple of points and a little reassurance:

1) We saw (some) of this coming. Unlike the Bear Stearns situation, Lehman's demise follows months of speculation that the bank was in severe trouble. Its failure will be a problem for some time, but the slower pace of its descent gave markets some time to react.

2) Merrill Lynch did stocks a favor. By getting bought out by Bank of America, Merrill removed a huge piece of what would have most likely been a massive drop in its share price and a further drag on broader markets. Unfortunately, Wall Street still isn't sure what to make of the $50 billion deal. Bank of America fell 20 percent on the news, while Merrill's stock jumped as much as 19 percent before pulling back to fall after-hours (remember, Merrill shares are off about 70 percent this year).

3) Pulling out the stops. The Treasury might not be bailing out Lehman, but there's a really massive amount of government cash flowing in to support the sector. The Fed is taking all sorts of assets as collateral (a move that will be heavily debated). New York Gov. David Paterson offered AIG a "bridge loan" worth up to $20 billion in liquidity to help the country's largest insurer stay solvent. That's good news. AIG was lobbying the Fed for help as it scrambled to raise capital, and Bank of America CEO Kenneth Lewis said a failure at AIG would be a "much bigger problem" than Lehman's implosion. AIG shares are still off more than 50 percent in the day. The government is asking JPMorgan and Goldman Sachs to lead a $70 billion to $75 billion lending facility for the insurer. We'll see if it works.

4) Some sectors are OK. Only a few names escaped the bloodbath today, but Coca-Cola managed a gain. Also, oil dropped below $100 a barrel, and with crude prices off by a third for the year, some companies who issued dire earnings guidance because of record energy costs will get a bit of a break in the second half (whether the slow economy will keep their customers spending is a separate issue). The dollar rose on the day's news, too.

5) It could have been worse. Today's drop is tough to take, but it was no Black Monday. Sellers may have dominated, but trading wasn't halted and many market watchers expected worse. "It's more than one would want to see in a single day but not a disaster," said Sara Johnson, managing director of global macroeconomics at Global Insight. Still, she sees stocks remaining weak through the end of the year, with banks and ailing, credit-dependent companies (like automakers) facing the biggest challenges.

Very little of the above argues that this week will be anything but a roller-coaster ride. Funding issues at AIG (and, for that matter, Washington Mutual) will dominate headlines. The Fed's meeting tomorrow will help clear up the government's plan to keep the economy from sinking. Let's hope for some better news.