Traders seem to be drawing a line in the sand at Dow 14,000. The blue chip index flirted with the 14,000 mark again Tuesday, but the rally couldn't sustain itself into the closing bell. Perhaps there's just too much rumbling below in the credit markets to justify such a cork-popping event, even with a growing list of strong earnings reports and news of more mergers. After trading as high as 14,021.95 intraday, the Dow Jones Industrial Average marked yet another record, gaining 0.2% to close at 13,971.55 and the Nasdaq Composite hit a new six-and-a-half-year high, closing up 0.6% at 2712.29. The S&P 500 slipped 0.1% to close at 1549.38 after trading above 1555 intraday. "We know the problems out there about subprime and the credit markets, we just aren't sure of the lag time between events and a view into what the effects will be," says Art Hogan, chief market analyst at Jefferies & Co. Indeed, traders spent much of the day chattering about the true losses at two Bear Stearns ( BSC) hedge funds -- the High-Grade Structured Credit Strategies Fund and its sister vehicle, High Grade Structured Credit Enhanced Leveraged Fund. In March, the more highly levered fund had $638 million in equity, and the less levered fund had $925 million, according to The Wall Street Journal. The funds' manager Ralph Cioffi and his team at Bear have been trying to "mark to market" the subprime securities that primarily make up their collateralized debt obligations -- pools of loans and bonds backed by subprime paper. Insight into how much these funds are actually worth and how they priced these assets will help the rest of the market assess the potential damage at other funds, and the potential liquidity-drying ripple effects.
In this opaque market, "any new information on price discovery is valuable," says Chris Vincent, head of fixed income at William Blair & Co. According to The Wall Street Journal, Bear Stearns told investors in the hedge funds late Tuesday they are worth virtually nothing, with the more highly levered fund worth zero cents on the dollar, and the less leveraged fund worth 9% of its value at the end of April. A Bear Stearns press release is expected later Tuesday. The fear is that such a worst-case scenario with the valuations could cause many more funds than expected to mark-to-market their portfolios. The next domino would be banks further tighten the strings on their lending to hedge funds through their prime brokerage business. This means investors that borrow to invest may have to pay more for the money they've been using. This might mean funds sell other assets to cover those costs, and that could include high-yield bonds and leveraged loans, both of which have also suffered losses of late. Bear Stearns was down more than 3% in recent after-hours trading, after falling 0.3% during the session. Bear Stearns wasn't the only brokerage firm to suffer Tuesday under the weight of the subprime worries. Merrill Lynch ( MER) posted a 31% year-over-year increase in profits, but its stock fell 1% even though the company claimed that the subprime fallout will be contained. It was Merrill's prime brokerage division in the first place that sparked the Bear Stearns hedge fund collapse when the firm demanded the funds post more in collateral as the subprime market came under fire.
At the very least, the Bear Stearns news could stem that Dow 14,000 run Wednesday as subprime concerns will likely be on the docket during Federal Reserve Chairman Ben Bernanke's semiannual testimony on Capitol Hill. Investors don't expect Bernanke to stray from his generally hawkish, but data-dependent mantra. Then again, if you believe history is a guide, his testimony is likely to move the Treasury market -- even if just temporarily. Thomas Higgins, chief economist at Payden Ryel notes that last year when Mr. Bernanke gave his testimony, 10-year Treasury bond yields rose to an intraday high of 5.17% before retreating all the way back to settle at 5.05%. That same day, the S&P 500 stock index rallied 1.9% on expectations that the Fed was going to pause its tightening cycle.