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Psychology Sours, Stocks Sink

Liz Rappaport

Whether or not Monday's stock market plunge is the beginning of the end of this rally is a matter of psychology, not necessarily data.

Investors were ready for some austerity Monday after gorging on a nearly straight-up run since mid-July. After the S&P 500 hit a six-year high last Wednesday, enough catalysts piled up to tip the scales, sending the S&P on its largest drop in over four months and the Dow Jones Industrial Average plummeting more than 150 points. But most of the excuses were psychological and not necessarily fundamental flaws for equities.

The dollar continued to break down, which rattled investors' nerves regarding the U.S. economy. The price of crude oil climbed, and bad news for Wal-Mart(WMT Quote) and Ford(F Quote) gave investors an excuse to take some profits.

The Dow dropped 1.3% to close at 12,121.79 while the S&P 500 dropped 1.4% to 1381.95; the Nasdaq Composite fell 2.2% to 2405.92. The declines were broad based, with 27 of the 30 Dow stocks in the red, and 78% of NYSE and Nasdaq volume declining.

Among Dow components, General Motors (GM Quote) and Boeing (BA Quote) fell more than 2.7%. In the Nasdaq, Google(GOOG Quote) dropped 4%, while shares of XM Satellite Radio(XMSR Quote) fell more than 5%.

Ford(F Quote) dropped 4.2% on news that the company plans to raise $18 billion of debt to fund its restructuring plan. The plans may include a $3 billion convertible security that would convert into equity shares of Ford under certain conditions, according to several reports.

Whether this is the "buy the dip" moment so many investors have been waiting for, or a sign that Christmas came early this year is hard to tell.

"It is the top," says Woody Dorsey, president of Market Semiotics, a research firm that specializes in behavioral economics. "I'm not afraid to say it."

According to Dorsey's measurements, the market hit a 100% bullish reading on Wednesday, which hasn't happened since 2000. Extreme bullish sentiment combined with a rash of initial public offerings and huge leveraged buyouts mean the market is boiling over. Dorsey says this is an interim top, meaning it is likely to last about three months.

Others are waiting to make declarations. "It is unclear," says John Bollinger, president of Bollinger Capital. "We're in a decision area and we should be looking at the market's reaction to the data, how the market handles the difference between expectations and reality," as a guide to how well stocks will hold up going forward.

There is plenty for the market to react to this week. Federal Reserve Chairman Ben Bernanke speaks Tuesday and Friday, and several regional Fed presidents are on the circuit this week. Existing- and new-home sales come out, as does the Fed's preferred inflation gauge, the core personal consumption expenditures index. Investors can look forward to same-store sales reports Thursday.

As for Monday, investors took Wal-Mart's disappointment darkly. Black Friday delivered, but Wal-Mart's same-store sales warning trumped the 6% increase in overall Black Friday sales and the 19% increase in Thanksgiving holiday-weekend sales, as reported by the National Retail Federation. Wal-Mart projected it will report a 0.1% decline in same-store sales this month, which sent its shares down 2.71%.

Shares of other retailers also suffered Monday. The S&P Retail Index dropped 1.2%, as shares of Target(TGT Quote) and J.C. Penney(JCP Quote) fell 1.1% and 2%, respectively. J. Crew (JCG Quote) tumbled more than 7% on a CIBC downgrade, which followed a 22% rise in the stock last week.

Having gone into Thanksgiving with high hopes for retail sales, the market doesn't know what to look to next, says Marc Pado, chief market analyst at Cantor Fitzgerald. This is the early start of a two-week seasonal "void" between Thanksgiving and New Year's, when investors aren't sure what to latch onto, he adds. Pado expects the market is halfway to what he predicts will be a 3% decline for the major indices before they turn up again for a classic Christmas rally.

"We're probably overreacting to the weak dollar, and we're probably overreacting to Wal-Mart," says Art Hogan, chief market analyst at Jefferies & Co. "The punishment doesn't fit the crime, and the world didn't change overnight."

Still, investors came back from the holiday weekend to find the dollar had slid past the psychologically important $1.30 mark vs. the euro, which revived concerns about foreign investment in U.S. assets. The dollar ended the day marginally stronger than it did Wednesday against the euro and the Japanese yen. After trading as high as $1.324 intraday, the euro dropped 0.2% on the day to $1.313, while the dollar rose 0.5% to 116.08 yen.

Despite worries about foreigners' waning interest in Treasuries, they rallied as stocks fell. The 30-year Treasury bond jumped 10/32 to yield 4.61%; the 10-year note gained 5/32 to yield 4.53%. The two-year note added 1/32 to yield 4.72%.

Stocks were set up for this drop, according to technicians. While the confounding overbought condition persisted for months, the S&P 500's recent push to 1400 and beyond showed signs of weakness, including lower highs for the momentum indicator, writes John Roque, technical analyst at Natexis Bleichroeder.

"The market was extended or overbought enough to believe that a corrective phase should have occurred or should occur," Roque says, stopping short of predicting how deep or how far the market may decline.

The price of oil climbing past the psychologically important $60 per barrel mark added to the pile of negatives Monday. Oil rose 1.84% to close at $60.33 per barrel.

The problem with psychology is that one man's sell signal is another's buy.

To wit: If the worst same-store comparison for Wal-Mart in 10 years produces this reaction, "maybe things aren't that bad," says Bollinger, acknowledging that the big down day is a warning, "but not a glaring call to panic."

Pado agrees, adding that Wal-Mart's misfortune may well be other retailers' gains come Thursday's same-store sales report.

Indeed, investors who sat out the summer rally have repeatedly expressed frustration about never finding a good solid down day to get back in. "This gives people more opportunity to buy in," says Hogan.

Whether the market's drop is a pause that refreshes or the decline that provides the kicker to what has been a year of antiseasonal trends, no one can know yet. The best option may be to read up on your Freud.