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Late Rally Falls Just Short

Liz Rappaport

Updated from 2 p.m.

It's easier to buy a correction than a mere dip.

The major stock market indices finally have had their long-awaited correction, marking a 10% decline from recent highs. And given that it's been four years since stocks have seen a move like this, some investors are feeling relieved.

Thursday's early selling brought the level of panic in the markets to new heights. The flight to quality trade is on in short-term Treasury bonds, as hedge funds liquidate stocks indiscriminately to meet investors' redemptions requests. The carnage is no longer at the margin or focused mostly on risky assets -- and that made Thursday an easier moment to be a buyer.

After falling as much as 343 points around midday, the Dow Jones Industrial Average stormed back in the last hour of trading to close down just 15 points. The S&P 500 briefly fell through its March low of 1374.12 before recovering to trade around 1400.

James Paulsen, chief investment officer at Wells Capital Management, says he added to his allocation to the financial sector this week. So far that's paying off. The Amex Securities Broker Dealer Index was rising Thursday even while the broader market was enduring a selloff. Paulsen is also bullish on cyclical industrials and basic materials sectors, which are also victims of the panic selling.

Still, a wild last hour that lapsed into selling before giving way to a late rally pointed out the risks that coming days will see more forced selling.

"If these guys [hedge funds] need to raise money, they can't sell their subprime loan paper," says Marc Pado, chief market analyst at Cantor Fitzgerald. "They sell what's liquid."

Hedge funds, like many others, have suffered huge losses in the wake of the housing market's collapse. Asset classes and derivatives connected to the mortgage-backed securities market plunged in value, and liquidity in the credit markets seized up.

The price of many types of securities started moving in odd directions, which sparked greater losses and more hedge fund blowups. The ensuing fright has led to redemptions en masse by skittish investors hoping to get their money out of the hands of risk-oriented hedge fund managers.

Sectors like basic materials, which have been havens for hedge funds due to the buyout and private equity rumor-mill, are seeing massive declines. Rio Tinto(RTP) and Alcoa(AA) each fell as much as 10% before regaining some ground in the afternoon.

Blue-chips like IBM(IBM) and General Electric(GE) haven't been spared either.

"Look at T-Bill rates," says Ken Fisher, founder of Woodside, Calif.-based Fisher Investments. "The spread between fed funds rates and T-bills should not be this elastic. This suggests to me that liquidity is being horded."

The shortest-term Treasury bills, like the four-week and three-month Treasury bonds, are safe places to park money, says Don Kowalchik, fixed income strategist at A.G. Edwards.

The yields there reached lows not seen in over a year at 3.4% for the three-month and 2.43% on the four-week -- down 1.6% in just one day. That's compared with a fed funds target rate of 5.25% on overnight borrowings.

"Today is a test day a little bit," says Kowalchik. "At this point it's not about why, but when is it going to stop?"

The Federal Reserve has refrained from cutting the fed funds rate despite the demand for cash reserves by banks, and despite the problems companies are having borrowing short term money. The commercial paper programs for troubled companies like Countrywide Financial(CFC) have hit a wall. Its short-term debt was yielding over 12% Thursday morning.

Countrywide fell 19% Thursday, after an 18% plunge Wednesday.

The Fed injected anther $17 billion of liquidity through open market operations to bring down the effective fed funds rate, which is the rate banks use to lend to each other overnight to maintain stable cash reserves. That rate usually matches the fed funds target rate of 5.25%. Banks are required to have a certain amount of reserves daily. When there's panic in the markets, banks hoard cash and drive up the rates they use to lend to each other bring that rate above the fed funds target rate.

But St. Louis Federal Reserve President William Poole said Wednesday night the Fed is not going to cut the target rate unless there is a financial "calamity." So far, it seems that a 10% correction and concerns about Countrywide going bankrupt don't fall into that category.