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BusinessWeek.com
May 12, 2006
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May Showers on Wall Street

Soaring commodities, solid economic data, and a falling greenback are clouding the markets with inflation worries

Spring was in the air on Wall Street, as the Dow Jones industrial average climbed to levels not seen in six years. On May 10 the Dow average finished at a new six-year closing high of 11,642.65, within 100 points of its all-time peak. Then the clouds thickened on May 11, when the Dow and other major indexes took their biggest tumble since Jan. 20. The next day, losses deepened.

What caused the sudden slide? Early in the week, the markets gained on strong earnings growth and optimism that the Federal Reserve might pause from its interest-rate tightening cycle. Then a perfect storm of surging commodities futures, solid economic data, and a weakening U.S. dollar brought inflation fears back to the foreground -- leaving some experts to believe the Fed might not be done after all.

AT A CROSSROADS. "What has investors worried is that the Fed will move further on rates and that inflation will erode the profit picture," says Joseph Battipaglia, executive vice-president and chief investment officer for Ryan, Beck.

Based on technical measures, stocks may have reached a critical juncture. During similar pullbacks in March and April, the broader Standard & Poor's 500-stock index found support at its 50-day moving average, says Chris Johnson, managing quantitative analyst at Shaeffer's Investment Research. The index was looking to find its footing there again during trading on May 12. "We really are at a crossroads," Johnson says.

Even after the two-day slide, the Dow average was still up 6.2% since the beginning of 2006, outpacing gains of 3.4% for the S&P 500 and 1.7% for the Nasdaq, thanks to strength in industrial names. Expectations about the Fed have played a key role in stocks' strong start this year, analysts say. For example, on Apr. 18, the S&P 500 enjoyed its biggest one-day surge in about a year, following Federal Open Market Committee minutes showing most of its members expected an end to rate hikes soon.

SECOND-QUARTER SLOWDOWN. Stocks have also benefited from another quarter of upbeat earnings reports, including results from Apple (AAPL ), General Motors (GM ), and Google (GOOG). On May 10 the S&P Investment Policy Committee said it expects companies in the S&P 500 to report an overall 13.9% year-over-year gain in first-quarter profits. That would mark the 16th consecutive quarter of double-digit earnings growth.

Still, earnings growth is expected to slow in the second quarter. And high-profile warnings, such as the lowered outlook from PC maker Dell (DELL ), could keep a lid on tech stocks.

Surging commodities prices have been sparking worries about inflation and dampening stocks. Gold futures jumped to $719.80, a 26-year high, on May 11, while copper, nickel, and zinc hit new records (See BW Online, 5/9/06, "Copper's Golden Hue").

INFLATION FEARS.  Crude oil futures were at $73.32, nearing the all-time high set in April. The high prices call into question the idea that the Fed will take a break from rate hikes, some analysts say. "Markets finally seem to be getting the message," wrote David Lynch, North American economist at Merrill Lynch, in a May 12 report. "The recent surges in energy and base metal prices have little to do with growth fundamentals and a whole lot to do with speculative action."

Strong economic data have also fanned inflation fears. A report released on May 12 said import prices jumped 2.1% in April, well above the consensus of 1.2%. The same day, the March trade deficit of $62 billion was narrower than the Commerce Dept.'s previous assumptions. "We believe that this report should add to inflation concerns at the Fed," writes John Ryding, chief U.S. economist at Bear Stearns.

Such numbers have taken on added significance as new Fed Chairman Ben Bernanke has repeatedly stressed his reliance on them. On May 10 the Fed raised the key federal funds rate 25 basis points, to 5%, as expected (see BW Online, 05/11/06, "Interest Rates: Look, Ma, No Pause!"). In an accompanying statement, the Fed said future tightening will depend "importantly" on incoming data.

WEAKER BUCK.  Next week's inflation data should provide some direction. The April producer price index is due on May 16, while the consumer price index follows on May 17. In both cases, energy prices are expected to push headline figures higher, says Action Economics. A surprise from either gauge, particularly excluding food and energy prices, would likely change projections about the Fed's next move.

Let's not forget the falling dollar (see BW Online, 05/03/06, "Will the Falling Dollar Hit Asia?"). Central banks in Europe and Asia have begun to lift rates even as the Fed winds down its own tightening cycle. Early on May 12 the dollar was down year-to-date 6.7% vs. the yen and 8.5% against the euro. "We think that there is more to come," writes Henry McVey, chief U.S. investment strategist at Morgan Stanley.

Economists are also keeping an eye on the slowing housing market (see BW, 05/15/06, "Why the Housing Bubble Won't Burst"). A weaker housing sector had been expected to reduce inflationary pressures and set a favorable backdrop for stocks and bonds, some analysts say. "Now people are starting to worry that the Fed isn't going to have the luxury to stop at its next meeting," says Brian Gendreau, investment strategist at ING Investment Management. "What the market really hates is uncertainty about the Fed."

SHIFTING GEARS.  Amid these concerns about inflation and the Fed, stocks are headed for a 5% correction, says Peter Cardillo, chief market analyst at S.W. Bach. "I don't think it'll be long-lasting," he says. "Metals and mining stocks will probably continue to do well, but even they probably will be subject to some sort of correction."

Other analysts are more optimistic. Stocks may have a "floor" below which they're unlikely to fall, writes Jeff Kleintop, chief investment strategist for PNC Advisors, in his May investment outlook. "Will the old adage 'sell in May and go away' prove to be prescient this year as stocks follow the typical midterm election-year pattern of summer weakness?" he says. "We think this is unlikely without further gains."

The timing was right for markets to shift gears, others say (See BW Online, 4/26/06, "A Savvy Seasonal Stock Strategy"). Wrote Barrington Research analyst Alexander Paris on May 10: "With the economy slowing and the earnings season over, it is a logical time for the market to start making a transition, which generally involves some kind of correction of narrow trading range." A spring shower may be natural, but it remains to be seen if this dip is part of a larger storm or just a squall.