Stocks Face Harsh New Reality

If the first half of 2007 was characterized by a crescendo of risk appetite, embodied by record highs for major averages and blockbuster M&A activity, the second half is likely to be differentiated by a more sensitive stomach. Signs are emerging of the end of the easy money leveraged buyout boom, which could cause indigestion for corporate bond and stock investors alike.

The bull market isn't necessarily over, but the path ahead is likely to be rockier than in the first half of the year, when the Dow Jones Industrial Average rose 7.6%, while the S&P 500 gained 6% and the Nasdaq Composite gained 7.8%.

Despite the gains, a late February/early March swoon and the more recent failure of two Bear Stearns(BSC) hedge funds awakened investors to the dangers of a credit crisis. A "credit crunch" has been averted thus far, but the fallout has included struggles for several leveraged buyout-related deals to get priced in the junk bond and leveraged loan market. The key question has become how fast and furiously liquidity will drain out of the credit markets, and what the ensuing ripple effects will be on the stock market.

"It could be a quick crash and burn or a slow-motion train wreck," says T.J. Marta, fixed-income strategist at RBC Capital Markets. By crash and burn, he means a crisis involving a contagion effect where more hedge funds implode as collateralized securities, called CDOs, are repriced at much lower levels, causing lending standards to tighten up, banks to make margin calls, and hedge fund investors to dump assets to cover their losses.

The slow-motion train wreck, on the other hand, would be a more gradual tightening of lending standards that results in wider risk premiums and incrementally restricts low-quality companies' and individuals' access to credit.