The credit markets are literally holding stocks hostage.
In the week ahead, traders say the dysfunction in credit markets will continue to dominate, and they expect the stock market to keep testing lows in choppy trading.
"It'll be a test, but it'll be a pass, fail test," said Art Cashin, director of floor operations at UBS.
He said stocks could test the 11,600 level on the Dow and 1270 on the S&P 500. "The credit markets are preparing for worse things than the stock markets have priced in so far," Cashin said. "In some cases, selling begets selling."
Cashin said news this past week that Thornburg Mortgage and Carlyle Capital failed to make margin calls, raises the specter that more margin calls are yet to come, and selling will hit not only mortgage securities but other asset classes, including stocks.
There is some significant economic data in the week ahead, including retail sales for February and consumer price inflation data.
On Monday, wholesale trade is reported at 10 a.m. Tuesday's reports include the NFIB small business survey for February at 7:30 a.m. and the international trade data for January at 8:30 a.m. The federal budget is reported Wednesday at 2 p.m. On Thursday, weekly jobless claims are reported at 8:30 a.m. Retail sales and import prices are released at 8:30 a.m. and business inventories for January are reported at 10 a.m.
On Friday, the consumer price index is reported at 8:30 a.m. and consumer sentiment is released at 10 a.m.
The Dow lost 3 percent for the week, while the S&P 500 lost 2.8 percent and the Nasdaq fell 2.6 percent. Utilities were the best S&P sector, gaining 0.06 percent. The worst group were the financials, down 5.95 percent, followed by energy, off 3.34 percent.
Oil rose 3.25 percent for the week, closing at $105.15 per barrel. Gold gained just 10 cents per troy ounce for the week, to $972.20 per troy ounce. The dollar continued to buckle under, falling 1.1 percent against the Euro and 1 percent against the yen.
The 10-year treasury fell 3/32 for the week, raising its yield to 3.543 percent, while the two-year gained 7/32 to yield 1.530 percent, its lowest yield since March, 2004.
The past week saw plenty of wild action in credit markets, particularly in mortgage securities, where selling pressure was fierce. Other parts of the credit markets were also impacted.
"The two-year swaps are closest to the highest level ever today. It was actually worse (Thursday) but this is the highest weekly close," said CNBC's Rick Santelli. Investors use swaps to hedge or speculate on interest rate moves, and their spreads typically grow with risk aversion.
"The real debate, I think, is are the credit markets telling us that it's going to get worse or are the credit markets in a state of the actual marking down process?," he said. "I think there's a lot of debate there, but my own personal opinion is that we're not going to be get more of a spiral. This is the spiral."
Stocks Get "Crunched"
MKM Partners chief economist Michael Darda says, "I was a lot more bullish when we had spreads a lot lower than they are now." Darda said he expects economic data to be weaker not only in the week ahead, but for awhile, as it's a lagging indicator. For stocks, he expects more selling.
"I think the bulk of selling is behind us, but I'm not confident at all that we won't go down another 5 percent. If you're a long term investor, it's ok to buy into this weakness. But if you're not, it's working against you," he said.
Brian Rauscher, director of portfolio strategy at Brown Brothers Harriman and Co, said stock investors will keep watch on those credit markets in the week ahead but also the Fed's next meeting, March 18, will begin to become a bigger part of street talk. He also said Friday's negative jobs data will have a ripple effect.
"What we're going to deal with now is all the economists are going to throw their hat in the ring on the recession call," with predictions of how long and how deep. The market, he says, will have to digest that information and the stock calls that come with it.
(For instance, J.P. Morgan's equities strategist Thomas Lee today wrote that he is reviewing his forecasts based on the firm's Friday call that the economy entered a recession in January)
What to Do?
"One of the things I think investors should be doing here is if you have some powder, let the market's gyration create opportunity for you. That's why people like Wilbur Ross and Warren Buffet do. They let fear and irrational trades create opportunity for them," Rauscher said.
Coincidentally, Buffett was a guest host on "Squawk Box" this past Monday and Ross is a guest this coming Monday.
Rauscher said he's been looking over the battered mortgage companies shares for opportunities after Thornburg's negative news. He said last week's big opportunity was in the muni bond market, where high yields made for some attractive investments.
"I think in this environment...be a scavenger. When they take down a whole group, dig into that group and see if it makes sense," he said.
One group he is beginning to look over again is retail, which had a bit of a recovery run and subsequent decline. He said he is not full overweight but suggests buying in on down days. Rauscher's favorite group is energy - equipment and drillers and he's also been invested in defensive plays.
"Some areas I like on the defensive are food products, names like General Mills , Conagra , Hormel , Campbell Soup , Heinz . They haven't participated as much as some of the other staples," he said.
This past week, he downgraded the information technology sector to 'market weight minus' from 'market weight plus' because of signs of weakening in the sector. He noted that the sector's fourth quarter upside surprise ratio was among its best in the past 14 years, but forward guidance has been poor, hurting share prices.
What to Watch
Fed Chairman Ben Bernanke will be speaking at the National Community Reinvestment Coalition Annual Meeting Friday at 1 p.m. His topic is fostering sustainable home ownership but he will not take questions. Fed Governor Randall Kroszner is also speaking in the week ahead. He will be at the American Bankers Association Spring Summit in Washington Tuesday at 10 a.m.
Also, the Wall Street Journal holds an economics conference in California starting Wednesday. Texas oil investor Boone Pickens is among the participants.
CNBC's Mike Huckman points out that investors should keep an eye on the FDA this week. He says it's a very big week for big biotech. On Thursday, an FDA Advisory Committee will decide whether to recommend restricting the use of anemia drugs from Amgen and Johnson and Johnson for use on cancer patients getting chemotherapy.
"Some investors may also trade around the posting of the agency's documents for the meeting, which will show up on the FDA website early in the week," Huckman says.
He also says watch Genentech, which meets with analysts in New York Friday. "In the wake of Genentech recently pulling off the surprising FDA win of Avastin for breast cancer, many analysts believe the company will raise, or at least, narrow the range of its guidance at its annual analyst meeting" he says.