Stocks dropped sharply for a second straight day Wednesday, tumbling to their lowest level in three months amid mounting concern over inflationary pressures.
“The market is concluding that the Federal Reserve is going to raise interest rates higher than had been previously expected,” observed Marshall Front, chairman of Front Barnett Associates in Chicago.
The Dow Jones industrial average dropped 123.75 points, or 1.19 percent, to close at 10,317.36.
The sell-off hit small stocks particularly hard. The Russell 2000 index of smaller-company shares fell 18.86, a 2.87 percent downturn, and closed at 644.98.
What staggered Wall Street was a combination punch: An economic report showed more evidence of rising inflation, while a Fed official’s speech signaled that keeping inflation in check will require higher interest rates. At the same time, high-profile profit warnings as the quarterly earnings season gets under way reminded investors that corporate earnings may be vulnerable to the economy’s turbulence.
Those difficulties helped generate a 94-point sell-off in the Dow on Tuesday. Including Monday’s modest decline, the first three days of this week have seen the blue chips plunge more than 251 points, or 2.38 percent.
Wednesday’s market reacted first to a disappointing economic report that showed unexpected weakness in the nation’s service sector. Perhaps more disconcerting, the ISM Non-Manufacturing Index also showed that prices employers paid for raw materials jumped to the highest level since the survey was created in 1997.
“The surge in energy costs is hurting many families and it was just a matter of time before it showed up in the data,” said Naroff Economic Advisors economist Joel Naroff. “Unless energy costs drop soon, and that doesn’t look to be the case, the holiday shopping could be at risk,” he said.
“An extended slowdown is possible and that could come equipped with rising inflation,” Naroff added. “It’s ugly time for the Fed and the markets.”
The ISM report sent investor spirits lower Wednesday morning. Then Thomas Hoenig, president of the Kansas City Federal Reserve Bank, added another negative, when he told an audience that inflation is the “biggest risk” facing the U.S. economy.
While Hoenig stressed that he expects the economy to fare well in 2006, investors chose to focus on the hawkish tone of his references to the rising cost of energy, raw materials like steel and cement, and labor.
While high gasoline costs can hit consumer spending, what the Fed is growing nervous about is something more insidious: the spookyprospect of a spiral of inflation that would be ignited by higher energy prices and keep feeding on itself.
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Only a few months ago one Fed official suggested that Alan Greenspan’s 15-month-old program of raising interest rates might be entering the “eighth inning,” leading market players to think the Fed might be done raising rates as early as February.
But as higher costs have started showing up in recent economic reports, many investors have now started to think the Fed will likely continue pushing rates higher well into next year.
Higher rates hold down stock prices. And that’s likely a reason the broad Standard & Poor’s 500 index dropped 18.08, or 1.5 percent, to 1196.39 Wednesday, and why the technology-heavy Nasdaq composite index dropped 36.34, or 1.7 percent, to 2103.02.
Treasury bills, which typically move opposite of stocks, rose Wednesday; the 10-year bond went up 3/32, to yield 4.35 percent.
Another issue weighing on Wednesday’s markets, noted Marshall Front, is the fact that “the energy group really fell apart.”
Energy stocks have been particularly strong during the past 12 months–a trend that began long before Hurricane Katrina sent oil and gasoline prices into the stratosphere. Front says there’s evidence recently that investors have become “fearful we’re seeing a topping out in crude prices,” and are now selling their holdings to lock in their profits.
In fact, the price of crude oil for November delivery dropped $1.11, to $62.79 Wednesday. But the stock market, which in recent weeks had been hypersensitive to rising oil prices, slumped despite the decline.
The decline in such formerly high-flying energy stocks, including Dow component ExxonMobil (down 2.6 percent at $58.95) helped drag the market even lower.
Wednesday’s casualty list of cyclical stocks hit by the market downdraft was lengthy, including Caterpillar (down 2.7 percent at $56.22), Hewlett-Packard (down 3.8 percent to $27.47) and downtrodden General Motors (down 4.8 percent at $28.63).
Local stocks: Exelon fell 2.8 percent to $51.48, Brunswick retreated 3.5 percent to $36.65, and Morningstar dropped 5.5 percent, to $30.07
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