Toxic stew brewing for stocks

Getty Images Traders work the floor of the New York Stock Exchange.

Getty Images
Traders work the floor of the New York Stock Exchange.

In the worst selling wave since May, U.S. stocks dropped sharply with global markets, raising worries about whether a correction has begun.

The selloff was sparked by worries about global growth and trouble at a major Portuguese bank. This comes after the Federal Reserve announced an end date of October for its bond buying program, formalizing what markets had expected.

Overnight, weaker-than-expected Chinese exports and a stunning 19.5 percent drop in May Japanese machine orders stoked concerns that growth is not picking up as expected. Surprising declines in industrial production in France and Italy added to the unease, and French inflation fell to its lowest level since the recession.

Investors flocked to the safety of gold, U.S. Treasurys and German bunds, while tossing stocks and peripheral European debt, including Portugese, Italian, Spanish and Greek bonds.

The Dow skidded more than 180 points, or 1 percent in morning trading, its biggest decline since April 10, when the index closed down 1.6 percent. It was the worst intraday point drop since May 15, when it plunged 216 points. The Dow later pared its losses Thursday, as did the S&P 500, the Nasdaq and Russell 2000, which had been off even more.

The Dow has seen just nine declines greater than 1 percent this year, and has set a series of new highs, as has the S&P. The S&P was off 20 points at its Thursday morning low, its worst intraday decline since May 15 when it fell 26 points.

Read More Stocks drop sharplyon European woes, Dow down 140

“This comes as equities markets were priced for some pretty good news and some would argue priced for perfection. In that context, any little wobble creates an out-sized response,” said Robert Sinche, global strategist at Pierpont Securities.

Traders were focused on Portugal’s Banco Espirito Santo, under scrutiny since accounting irregularites surfaced in its holding companies in May. Parent company Espirito Santo International delayed coupon payments relating to some short-term debt securities, spooking markets further.

Read More Portugal concerns compound global stock selloff

“I think this is one where there’s an initial reaction. The linkages are not clear between the corporate entity that missed the payment and the bank—and the bank and everything else. Authorities in Europe are saying this is ring-fenced, and when you look at the market reaction, coming in a pretty complacent market, the CDS rate only got back to where it was in May,” said Sinche, referring to credit default swaps. “In the context of crisis we’ve seen in Europe, this is only a little tiny piece.”

The five-year credit default swaps for Portugal rose to 216 basis points, but Sinche notes that level remains less than half the high over the last year and is about the same level as in May.

Jack Ablin, CIO of BMO Private Bank, said he would hope the weakness in Europe, which appears to be worsening, prods the European Central Bank to take action. “They really do need QE. I think it’s a lesson for the Fed not to err on the side of restraint,” he said.

The Fed has been winding down its quantitative easing program, but has been reassuring markets it will not move quickly to raise rates. Stocks rallied Wednesday after the Fed released minutes of its last meeting, but traders focused on the QE wind-down as the selloff got underway Thursday.

“I’m not worried about it. I think we could actually rally back. There’s a lot of people on the sidelines with cash, and cash is just burning a hole in peoples’ pockets,” he said.

Ablin said he is worried about the earnings season, which got underway this week with a few major reports. But if earnings do present trouble for stocks, he expects a rebound.

“I think it represents an opportunity,” he said of the selloff. “Earnings will be over, and we’ll focus on what’s driving the market—the economy, liquidity and momentum. We’re still all in.”

Ablin said one trouble spot for the broader equity market is small caps. “The Russell 2000 is probably the most dangerous major market in the world. It’s wildly overvalued. It’s way overdone,” he said.

The Russell is having its worst weekly loss in two years, down more than 4 percent.

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