Stagflation Fears

Soft economic reports sent the market modestly lower this week:

Dow -0.2%
Nasdaq -0.4%
S&P; 500 -0.6%
S&P; Midcap 400 +0.1%
S&P; Smallcap 600 -0.3%

You would think the June FOMC meeting was behind us by listening to talk on the street. Already, people are looking ahead to the August meeting and asking if it will produce yet another rate hike. The culprit is, as ever, inflation data.

Yet, evidence of a softening economy is abundant. Some argue that slowing business conditions will prevent inflation from becoming a problem while others say that, no, in fact we’re in for both. That’s stagflation, one of the worst economic situations, and the one that made the 1970s such a stock market wasteland in America. The term itself is a fusion of stagnation and inflation, as in low economic growth coupled with rising prices.

The National Association of Home Builders (NAHB) reported its housing market index on Monday. It fell for the fifth month in a row, from 46 last month to 42 this month. That’s the lowest it’s been in 11 years. The index is a weighted average of separate measures including current sales of new homes, expected new home sales in the next six months, and the number of prospective buyers in new homes. When the index falls, it indicates a slowing housing sector. When it falls sharply, it indicates a crashing housing sector.

In June, it fell sharply. The report itself did not use the word “crash” nor the word “excessive,” but said that the fall was not consistent with a gentle slowdown in housing.

The implications of a slowing housing sector affect the whole economy because consumer spending is tied to household wealth. If a shopper lives in a home that has doubled in value on paper, he’s more likely to spring for a new car than if he lives in a home that’s worth less than he paid for it. A slow housing market means quiet cash registers and that spells economic trouble. This is the hard landing scenario that most economists have said we’d be able to avoid.

The NAHB report was not encouraging. It sent the Dow down 0.7% and the Nasdaq down 0.9%.

Then, as the cackles from that villain died down, Tuesday brought a hero on a white horse called housing starts. They rose 5% in June to an annualized rate of 1.96 million units. That’s strong, and soothed a market jittery after Monday’s report. Maybe the housing sector isn’t plunging quite as badly as thought the day before. The Dow managed a 0.3% gain, but the Nasdaq slipped 0.2%.

On Wednesday, healthy earnings from both FedEx and Morgan Stanley helped to continue Tuesday’s brighter tone. The Dow gained 1% and the Nasdaq gained 1.6%.

On Thursday, we returned to inflation and interest rate concerns.

Last week’s CPI report made everybody certain that the Fed will raise rates at next week’s meeting. Now, though, people are guessing that it might be by a full 0.50%, twice the recent 0.25% pace. That talk on top of the August rate hike talk has a lot of people watching the market and waiting, but not buying.

Treasury yields, meanwhile, are marching higher. They ended Thursday at multi-year highs of 5.23% for the 2-year to 5.21% for the 10-year. That’s pretty good compensation for a no-risk investment, and it keeps money out of stocks.

Few buyers means a falling market, and that’s what we got on Thursday. The Dow dropped 0.6% and the Nasdaq dropped 0.9%.

Before the bell on Friday, two things caught Wall Street’s attention: a nice acquisition announcement and a tepid durable goods orders report.

Anadarko Petroleum (APC) said it would acquire Kerr-McGee (KMG) and Western Gas Resources (WGR) in separate transactions worth a total of $21.1 billion. Merger and acquisition activity is a positive business sign because it shows that companies have cash on their balance sheets and that they feel confident enough in their future to use it.

However, the Commerce Dept. surprised us with a durable goods orders report far below projections. Economists thought orders for May would rise 0.4%. Instead they fell 0.3%, mostly due to tailspinning non-defense aircraft orders. A slowdown in durable goods orders means factories won’t be busy in the months ahead and that the economy will suffer as a result. The report was a tough read, though, because if we strip out transportation then new orders recovered 0.7%. That indicates that just plane factories are going to be sitting idle, and bad news in the airline business is hardly shocking anymore so the report didn’t weigh as heavily as first thought.

Stocks spent the morning in the red, climbed into the green by early afternoon, then finished the day in the red again. That’s how it’s been lately as investors have been unable to settle on a clear tone. The Dow fell 0.3% and the Nasdaq fell 0.1%.

Next week brings the FOMC meeting and the interest rate decision on Thursday. While that should provide some short-term direction, we’re already seeing attention paid to the uncertainty of the August meeting.

I have fresh reports on First Marblehead (FMD) and Yahoo (YHOO).

The former just signed a 3-year agreement with General Electric, validating its direct student loan marketing model. In this tepid market, it feels great to own a stock that keeps going up. We’ve gained 54% so far and aren’t done yet.

Yahoo is the official FIFA World Cup site partner, and the arrangement shows why the firm is positioned in the internet’s sweet spot as media converge. Find out why we own this great company, and why it’s better than Google (GOOG).

I’ll give you both reports for free when you try The Kelly Letter for a month. You can cancel during the month without paying more than a cent. That gives you a whole month to view my entire portfolio and spend as much time as you’d like reading archived notes, reports, and news commentary. I’d love to welcome you aboard.

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