Dow Slides 10% in Volatile Second Quarter

Investors Hunker Down With Gold, Treasurys as Volatility Spikes; EU Fiscal Uncertainty Remains

By TOM LAURICELLA
Volatility returned to global financial markets with a vengeance in the second quarter, sending investors fleeing from stocks world-wide and driving them into defensive investments, especially U.S. Treasurys and gold.

With the Dow Jones Industrial Average closing out the quarter at a new low for the year, the turn of events marks a sharp reversal in the "risk" rally that began last March, and the escalation of the tumult bears resemblance to the path of the 2008 financial crisis.

Now, the question dominating financial markets as the first half ends is how much longer the renewed bout of heightened fear will last. The answer, some observers say, is not anytime soon.

"A huge amount of confidence was pulled out of the market during this period," says John Brynjolfsson, investment chief at hedge fund Armored Wolf.

The Dow ended the second quarter down 1,082.61 points, or 10%, at 9774.02, its first quarterly drop since the first three months of 2009.

The challenge for investors is that the worries run the gamut of economic, fiscal and regulatory issues—none of which are likely to be resolved overnight. Such "macro" issues have pushed to the background "micro" positives, mainly continued good news from U.S. corporate earnings.

Against this backdrop, investors have hunkered down. They are waiting to see clear evidence that a recent bout of softer-than-expected economic news in the U.S. isn't the precursor to a double-dip recession. In particular, investors will be looking for renewed private-sector job growth to pick up the slack as government stimulus efforts wind down.

Investors also want reassurance that the global financial system isn't again in danger, this time as a result of the sovereign debt crisis in Europe. Key to that is seeing improvement in the interbank lending market in Europe, where banks have grown wary of lending to one another.

"It's a 'show-me' market," says Robert Doll, chief equity strategist at BlackRock Inc.

"Fresh in everybody's mind is the carnage of late 2008 and early 2009," he says. "Therefore, their mentality is to sell first, ask questions later and be content with earning 3% on 10-year Treasurys."

On the quarter's final day, the Dow slumped into the closing bell, losing 96.28 points, or 1%. That left it 12.8% below its 2010 high set on April 26—placing it firmly in a correction. The Dow stands 31% below its record close of 14164.53 from October 2007 but up 49.3% from its 12-year low of 6547.05 hit on March 9, 2009.

The Standard & Poor's 500-stock index posted its worst quarterly performance since the final three months of 2008 when the financial crisis was in full swing. With a 1% loss Wednesday, the S&P 500 fell 11.9% during the quarter to 1030.71.

Meanwhile, investors flocked to investments seen as safe havens. Gold rose 11.9% per troy ounce to $1,245.50, finishing the quarter just shy of its record high of $1,257.20. U.S. Treasury prices also rose sharply, driving the yield significantly lower. The yield on the U.S. Treasury 10-year note finished the quarter at 2.96%, down from 3.84% at the end of March and making Treasurys one of the best-performing asset classes for the quarter.
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The seeds of the second-quarter turmoil were planted in the first quarter as the Greek debt crisis began stirring. But as the second quarter got under way, investors viewed the problems in Europe as contained.

In late April, the Dow rallied to 11204.28 and the S&P 500 reached 1217.28, their highest levels since the week that Lehman Brothers filed for bankruptcy in September 2008. Reflecting that comfortable outlook, the Chicago Board Option Exchange's VIX, a measure of the S&P 500's volatility known as the "fear gauge," collapsed to readings below 15, its lowest level since 2007.

As the quarter progressed, the situation in Greece deteriorated rapidly and worry about "contagion"—the idea that the crisis would spread far beyond its roots—reared its head and slammed stock and bond markets in other debt-laden European countries. At the same time, some investors grew worried that China, in an effort to slow its booming economy, will end up slamming on the break too hard and derail a key global growth engine.

As if that wasn't enough, the May 6 "flash crash," when the Dow plunged 700 points in just eight minutes, raised concerns about the soundness of the day-to-day workings of the U.S. stock market.

With investors facing a laundry list of macroeconomic woes, the response has been an exodus from riskier investments that rode the initial wave of optimism about a global recovery starting last March.

Showing the renewed tumult, the VIX fear gauge jumped back to finish the quarter at 34.54. But more than just stocks took big hits from the selling. Copper, a key industrial commodity, lost 17% during the quarter and oil fell 9.7% to $75.63 a barrel.

In the bond market, the gap between investment-grade bonds and U.S. Treasurys rose to more than 2 percentage points from 1.5 in late April, according to Bank of America Merrill Lynch indexes. Junk bonds saw their biggest rally in history come to an abrupt end, with spreads over Treasurys jumping to more than 7 percentage points from around 5.5.

For stock investors, these big-picture concerns have all but erased the glow from good earnings news. "We had hoped 2010 would be back to stock picking, but so far that's not the case," BlackRock's Mr. Doll says.

Michael O'Rourke, strategist at brokerage firm BTIG, says that on a "micro" level, stocks look attractive for long-term investors willing to brave the volatility and uncertainty..

The stocks in the S&P 500 are trading at a price-to-earnings ratio of about 13.5 times 2010 estimates compared to a historical average PE around 16, Mr. O'Rourke says.

Conversely, he notes, U.S. Treasurys are extremely expensive by a widely watched measure. Usually, yields on the 10-year note are roughly comparable to the earnings yield on the S&P. Instead, the S&P is yielding more than 7% while yield on the 10-year dropped below 3% in the final days of the quarter. "On that basis, equities are much more attractive than Treasuries," he says.

Until the systemic fears and worries about a double-dip recession abate, investors seem to feel safer having the risk button on their portfolios switched off.

Robert Sinche, chief strategist at hedge-fund manager Lily Pond Capital Management, thinks the new quarter won't bring much relief. "There's going to be a lot more uncertainty over the next couple months," he says.

Part of the problem, Mr. Sinche says, is that it will take some time for the disruptions in the financial markets to work their way into the real economy. In the case of Europe, which has a reputation for shutting down in July and August, the true extent of any impact from the recent turmoil may not become clear until October when September economic data are published.

In the meantime, "every time we get a positive number, the sentiment is likely to be 'Yeah, but we haven't seen the impact of the spring,' " Mr. Sinche says.

As far as the U.S. is concerned, Barry Knapp, strategist at Barclays Capital, will be taking his cues from the labor market, and in particular, weekly jobless claims. Claims had dropped by roughly one-third from their peak by March, but that improvement stalled out.

"If jobless claims were to resume their downtrend … that would be a big plus for the capital markets," Mr. Knapp says. He argues that the recent softness in U.S. economic data reflects a normal easing off in the pace of the recovery after its initial surge last year.

As for the worries about Europe dragging down the global economy, he thinks they are overblown. "I don't think anybody was buying into Europe being an engine of growth," he says.

Others argue that the systemic worries, particularly concerns about Europe's banks, will slowly fade on its own accord - assuming they don't prove founded.

The outlook "may look bad now because we're working from a place of extreme risk aversion," says Sebastien Galy, senior foreign-exchange strategist at BNP Paribas. "But if you give it some time... and every day investors are a little bit less fearful than yesterday, they can release more capital to invest in risk."

Write to Tom Lauricella at tom.lauricella@wsj.com