Major indices sank Thursday as investors reacquainted themselves with the unpleasant possibility of stagflation.

An early reading of the first-quarter GDP showed that growth decelerated more than expected while prices climbed faster than expected. And as if to emphasize the point, crude oil prices -- which are at the very heart of slowing growth and rising prices -- reversed early losses and turned higher late in the day. Oil's rebound helped topple an already wobbly stock market as selling accelerated in the final 90 minutes of trading.

The

Dow Jones Industrial Average

plunged 128.43 points, or 1.26%, to 10,070.37; its fifth triple-digit decline in April. The

S&P 500

fell 13.16 points, or 1.14%, to 1,143.22. The

Nasdaq Composite

was lower by 26.25 points, or 1.36%, to 1,904.18, its lowest close since Oct. 14.

The tech-heavy index was helped lower by disappointing earnings from

JDS Uniphase

(JDSU)

, which fell 9.1%. (Tech earnings and guidance after the bell from

Microsoft

(MSFT) - Get Report

and

KLA-Tencor

(KLAC) - Get Report

were more upbeat.)

Breadth once again indicated far more determination to sell than has been evident in recent rallies. Decliners beat advancers by 2 to 1 on the

NYSE

, on heavy volume of 2.15 billion shares, and by 3 to 1 on the Nasdaq, where 1.9 billion shares traded hands. The market's nervousness was further reflected in the CBOE Market Volatility Index, which spiked 13.4% to 16.86.

As expected, investors fled cyclical stocks, those issues that would be most affected by a slowing economy. The Morgan Stanley Cyclical Index fell 1.21%. Traders also fled consumer discretionary stocks, such as

Home Depot

(HD) - Get Report

, which lost 2.6%.

Consumer staples, meanwhile, were favored, especially as

Procter & Gamble

(PG) - Get Report

posted strong earnings and issued positive guidance.

With investors scrambling out of cyclical issues, the oil sector's action was interesting to watch.

In spite of crude prices rising 16 cents to $51.77 (after briefly trading below the $50 level), the Amex Oil Index still fell nearly 1%. Pressure on the sector was led by

Exxon Mobil

(XOM) - Get Report

, which disappointed Wall Street with its earnings.

Underneath the move in the energy sector, and the market at large, there also may be the realization that a slowdown in the U.S. can't be too good for global growth and oil demand. Of course, some economists argue that this will help ease inflationary pressures and help the

Federal Reserve

achieve its plan for a "soft landing."

But this ideal scenario was far from traders' minds Thursday, which was understandable given the GDP report.

Double Whammy

It wasn't just that the U.S. economy grew only 3.1% in the first quarter, down from 3.8% in the fourth quarter of 2004 and below expectations for growth of 3.5%. Rising inventories in the quarter indicate that second-quarter growth will also

likely be hit as businesses will produce less while liquidating their stocks.

Compounding concern among investors, inflationary pressures also are rising close to the top of the Fed's comfort zone, as measured by the GDP price deflator. In other words, the Fed likely will feel compelled to maintain its "measured" tightening campaign, even as the economy slows. In addition, the red-hot housing market also likely has the Fed on alert.

That side of the equation was cast aside by the bond market Thursday, which besides the slower growth picture, again benefited as more investors fled equities. The price of the benchmark 10-year Treasury jumped 18/32, its yield sinking to a two-month low of 4.15%. (

So much for cooling the housing market

.)

And while consumer spending remained robust, rising 3.5% in the first quarter, energy costs have since been passed on down the production chain. Gasoline prices also caught up with crude oil.

"A slowing to about 2.5% annualized consumption growth remains a central risk to economic growth in the next few quarters," says Bank of America senior economist Peter Kretzmer.

Beyond its obvious impact on the domestic economy, a slower U.S. consumer also could have impact on global growth, which also would fuel a vicious cycle and further weakness.

Global Risks

As noted

here Monday, Merrill Lynch analyst David Bowers believes that when U.S. consumer spending growth slows, the U.S. supply chain in Asia would be negatively impacted. The first victim, of course, would be oil and energy assets.

And so oil's surging price could come back and bite its own tail. The bite of oil prices on growth is already being felt in various places outside the U.S., such as Japan, the Baltic states and France, according to International Strategy & Investment. "Oil works with a lag. It's now working and is likely to slow global growth in months to come," ISI says in a report Thursday.

Besides oil, higher U.S. rates are also accelerating risks of a global slowdown. Easy money here as helped fuel the carry trade and spectacular growth in emerging markets, which in turn have lent the money back to finance U.S. consumption of emerging market goods. U.S. corporate profits have also been boosted by investing into growth overseas.

According to an April Merrill Lynch survey of global fund managers, an increasing number believe the global economy is now in a late cycle expansion, as opposed to a mid-cycle. These perceptions, whether real or not, have a self-reinforcing effect, Merrill notes.

The implications are myriad for markets. Late cycle investors tend to be more cautious than midcycle investors, holding more cash and restraining exposure to equities, where they overweight consumer staples and pharmaceuticals and underweight utilities and consumer discretionary.

But according to the Merrill survey, late-cycle investors have remained overweight energy and material, "even to a greater extent than mid-cycle investors."

Trumping everything, of course, remains the future direction of oil prices. If global growth slows down enough, oil prices will fall and will reduce inflationary pressures, making it easier for the Fed, and other central banks, to engineer a soft landing.

Economists at ISI say they expect such a scenario. Markets will make up their minds, perhaps with the help of Friday's slew of economic data: the March employment cost index and personal income, as well as the University of Michigan sentiment survey and the Chicago PMI for April.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send

your feedback.