December 28th, 2011

U.S. stocks declined, halting a five-day advance in the Standard & Poor’s 500 Index, as the European Central Bank’s balance sheet increased to a record after a surge of bank lending to stem the region’s debt crisis.

Alcoa Inc. and Chevron Corp. dropped at least 1.6 percent as the U.S. dollar rallied, reducing the appeal of commodities. Bank of America Corp. (BAC) slumped 3.1 percent, extending yesterday’s retreat. The Morgan Stanley (MS) Cyclical Index sank 1.6 percent as Ford Motor Co. and Caterpillar Inc. (CAT) slid more than 2.1 percent.

The S&P 500 lost 1 percent to 1,252.51 at 12:45 p.m. New York time. The benchmark gauge erased its 2011 gain and fell below its average price of the past 200 days. The Dow Jones Industrial Average slid 119.05 points, or 1 percent, to 12,172.30. The Russell 2000 Index of small companies dropped 1.5 percent. About 2.1 billion shares changed hands on U.S. exchanges, or 34 percent below the same time a week ago.

“If the euro zone banks are too afraid to lend, that does not bode well for future growth,” Brian Jacobsen, who helps oversee about $209 billion as chief portfolio strategist at Wells Fargo Advantage Funds in Menomonee Falls, Wisconsin, said in a telephone interview. “The banks are not borrowing from the ECB in order to spur lending. It’s to shore up their balance sheets. That could lead to a credit contraction.”

Stocks slumped as the ECB’s balance sheet soared to a record 2.73 trillion euros ($3.55 trillion). The ECB last week awarded 523 banks three-year loans totaling a record 489 billion euros to encourage lending. So far, banks are parking the money back at the ECB. Overnight deposits at the central bank increased to an all-time high of 452 billion euros yesterday.

Italian Auction

Stock-futures rose in early trading today as Italy sold 9 billion euros ($11.8 billion) of six-month Treasury bills and borrowing costs fell from the previous auction as the government passed measures aimed at trimming the euro region’s second- biggest debt. A bigger test of the ECB’s lending on demand for European bonds comes tomorrow when Italy sells as much as 8.5 billion euros of longer-maturity debt.

“The easier part of Italy’s bond auctions this week took place earlier today,” Peter Boockvar, equity strategist at Miller Tabak & Co. in New York, wrote in a note today. “But a good test of the appetite for Italian debt will be tomorrow’s bond sales that have maturities past three years.”

Companies most dependent on economic growth led the declines in the S&P 500. Gauges of commodity, industrial and financial shares lost at least 1.2 percent. Alcoa (AA), the largest U.S. aluminum producer, retreated 2.2 percent to $8.60. Chevron fell 1.6 percent to $106.28. Caterpillar, the largest construction and mining-equipment maker, dropped 2.1 percent to $89.62. Ford retreated 2.5 percent to $10.54.

Banks Tumble

The KBW Bank Index (BKX) declined 1.6 percent as all of its 24 stocks fell. Bank of America lost 3.1 percent, the most in the Dow, to $5.31. Citigroup Inc. (C) erased 2.8 percent to $26.15.

Molycorp Inc. (MCP) slumped 12 percent, the biggest decline in the Russell 1000 Index, to $24.54. The price estimate for the owner of the largest rare-earth deposit outside China was cut to $39 a share from $57 by JPMorgan Chase & Co., which cited pressure on rare earth prices.

Traders pushed bearish options on Pharmasset Inc. to the highest level in the Russell 1000 Index, locking in gains before Gilead Sciences Inc. (GILD)’s $10.8 billion offer for the drugmaker is scheduled to close.

Implied volatility for 30-day puts to sell Pharmasset shares are 60.41 points higher than the level for calls, compared with the 18-month average of 8.12, according to data compiled by Bloomberg. The price measurement known as skew (VRUS) is 10 times higher for Pharmasset than it is for the average Russell 1000 company, the data show.

Pharmasset Shares

Pharmasset shares closed at $123.02 last week, the lowest price since Gilead bid for the Princeton, New Jersey-based company in November to gain its experimental hepatitis C treatment. MKM Partners LP and Tullett Prebon Plc say that while there’s about a 90 percent chance the deal will succeed, investors are buying options in case the transaction fails.

“The deal not closing is a low-probability event, but a high-impact one,” Walter Todd, who oversees $925 million including Gilead shares as chief investment officer at Greenwood Capital in Greenwood, South Carolina, said yesterday in a phone interview. “The downside if the deal falls apart is pretty significant for Pharmasset. People want to pay up for protection.”

- Rita Nazareth in Sao Paulo at Bloomberg.