Stocks rally on report of federal entity for bad debt; Dow up 410

Investors remained jittery throughout Thursday's session. The Chicago Board Options Exchange's volatility index, known as the VIX, set a new high for the year in trading Thursday before closing lower. Often referred to as the "fear index," the VIX at times rose to levels not seen since October 2002.

Mixed economic readings drew little attention as investors focused on the financials and the credit markets.

The Labor Department reported that initial claims for unemployment benefits rose by 10,000 last week to 455,000, due primarily to Louisiana's job losses from Hurricane Gustav. And the Philadelphia Fed said its regional manufacturing report improved to a 3.8 in September from a negative 12.7 in August. It marks the first positive reading since November.

Among financials, Morgan Stanley rose 80 cents, or 3.7%, to $22.55 as the investment bank sought a buyer or cash infusion to shore up its flagging share price. The stock has fallen sharply in the past week following Monday's bankruptcy filing at rival Lehman Brothers Holdings Inc. and a forced sale of Merrill Lynch to Bank of America.

The Russell 2000 index of smaller companies rose 47.30, or 6.99%, to 723.68.

Overseas, Japan's Nikkei stock average dropped 2.22% to its lowest closing level in over three years. Hong Kong's Hang Seng index lost 0.03%. Britain's FTSE 100 fell 0.66%, Germany's DAX index rose 0.04%, and France's CAC-40 fell 1.06%.

Contributing: Reuters

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