Midday Musings: Someone Say Stagflation?

Given its brief history, the Institute for Supply Management's nonmanufacturing index is generally considered to be a minor economic indicator. Yet the ISM's report on the services sector appeared to have a major impact on financial markets today as stocks and bonds reversed right after the report was released.

Again, the ISM survey is a secondary economic report, and I don't want to overstate its influence. Clearly, there were other issues weighing on equity proxies at midday. In addition to the ongoing warfare in the Middle East, stocks were pressured by a series of issues, including:

• Another flare-up of Enronitis amid revelations of Securities and Exchange Commission inquires at Adelphia Communications(ADLAC Quote) and Williams(WMB Quote), as well as an article in The Wall Street Journal that raised questions about Dynegy's (DYN Quote) accounting.

• Analyst downgrades of Dow components Caterpillar(CAT Quote) and 3M(MMM Quote), which helped offset Du Pont's (DD Quote) upside preannouncement.

• Renewed weakness in software stocks, including industry giant Microsoft (MSFT Quote).

Still, stock proxies turned abruptly lower after the 10 a.m. EST release of the ISM's report. Conversely, bonds reversed earlier losses and moved into positive territory.

The ISM reported its nonmanufacturing index fell to 57.3 in March from 58.7 in February. The index remains above 50, indicating expansion in the services sector, and the drop was not as large as the consensus expectations.

The disconcerting aspect of the report was in its subindices: New orders fell to 54.9 from 57.3, and employment remained under the key 50 level, rising to 45.5 from 43.6, while the prices paid index rose to 53.0 from 50.

The rise in the prices paid index renewed fears the Federal Reserve may have to raise rates sooner vs. later, although fed funds futures ratcheted down their expectations for a hike on May 7. Still, the combination of falling demand, shrinking employment and rising prices contained in the ISM's nonmanufacturing survey raised the specter of stagflation. Even if it's only a faint whiff, it's something that certainly bears close watching in the weeks ahead.

Stagflation was a term coined in the 1970s to describe a period of slow economic growth and high unemployment accompanied by rising inflation. Skyrocketing oil prices brought about by OPEC's embargo were a key element to the 1970s' stagflation. Crude futures have risen more than 30% since Feb. 1, although there were down at midday (the slide was expected after last night's report of stronger-than-expected inventories by the American Petroleum Institute).

Oil prices remain far below levels reached in the 1970s, but some see parallels between that era and today, what with Iraq renewing calls for embargo amid the rising tensions in the Middle East. As Israel expanded its operations in the West Bank today, Egypt's government announced it was cutting direct contact with the Jewish state while Lebanese Hezbollah guerillas shelled Israeli army positions in Northern Israel for a second-straight day.

As bleak as things look at midday for those long stocks (not to mention world peace), one market watcher who prides himself on being a contrarian suggests a rally is in the offing.

"My guess is that the late February/early March gains have now been consolidated and that the market is just about ready for the next rally phase," said Dave Hunter, chief market strategist at Kelly & Christensen. "The risks are great, and I see this as a last hurrah if it does occur. But now that the majority has turned more cautious, the odds of a sharp rally certainly have increased."

Hunter foresees the Nasdaq rising to between 2200 and 2400 in the ensuring advance and the Dow approaching 11,000. Still, the strategist's intermediate- to long-term view remains extremely cautious: "Beyond any rally, I still see a severe economic contraction and significant new lows ahead," he commented.

I don't disagree with Hunter's short-term rally call nor his long-term caution (although he is more concerned about deflation while I foresee inflation).

But it's hard to argue that the "majority" have turned cautious, judging by various sentiment indices. The CBOE Market Volatility Index was up 4% to 21.50 at midday but remains subdued relative to recent history.

Similarly, the equity put/call ratio remains well below 1.00, indicating more call buying vs. defensive puts. Yesterday, Merrill Lynch strategist Richard Bernstein reported his sell-side indicator -- which is based on the recommendations of major Wall Street strategists -- fell to 68.7% on March 28 vs. 69.6% in late February but remains "among the most optimistic in the indicator's history." The sell-side indicator has proven to be a reliable contrary indicator, as reported previously.

Sentiment indicators are far from infallible prognosticators, but the absence of heightened fears suggests still more downside to come before any short-term rally can commence.