U.S., Europe stocks slump before stress tests

By Jennifer Ablan and David Gaffen

NEW YORK (Reuters) - World stock markets dropped as investors readied for the release of government stress tests on the 19 largest U.S. financial institutions after the close on Thursday.

With stocks having rallied steadily for about two months, fund managers reduced holdings even though leaked reports suggest bank balance sheets may be in better shape than expected.

Surprisingly, investors didn't flock to their favorite safe haven of Treasuries. U.S. debt prices retreated sharply, pushing yields to five-month highs, after a weak auction of 30-year Treasury bonds reinforced a rout triggered early in the session by a decline in weekly jobless claims. Furthermore, the U.S. dollar fell against the euro and other currencies.

Bank stocks also had a rough day.

The KBW Bank Index .BKX of 24 large lenders, including 14 that are subject to the stress tests, dropped nearly 3.50 percent ahead of the results. The index had jumped 25.8 percent in the first three days of the week and had more than doubled since bottoming on March 6.

"From my perch, investors should sober up and reduce their holdings in financials now," said hedge-fund manager Doug Kass, founder and president of Seabreeze Partners Management. "Financial stocks are now priced to perfection."

The Dow Jones industrial average .DJI closed down 102.43 points, or 1.20 percent, at 8,409.85. The Standard & Poor's 500 Index .SPX ended down 12.14 points, or 1.32 percent, at 907.39. The Nasdaq Composite Index .IXIC finished down 42.86 points, or 2.44 percent, at 1,716.24.

Among other indexes, the Russell 2000 index .RUT was down 2.41 percent at 492.94. The New York Stock Exchange Composite Index was down 1.54 percent, at 5,800.09. The Dow Jones Wilshire 5000 Composite Index .DWC was down 1.53 percent at 9,269.29.