Soft Earnings Sideline Buyers - TheStreet

Soft Earnings Sideline Buyers

A rough start to the season sends stocks reeling amid more subprime woes and no relief from Bernanke.
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The stock market dropped Tuesday as earnings season commenced with a maelstrom of bad news. To top it off,

Federal Reserve

Chairman Ben Bernanke provided no heroic rescue in an academic speech that dissected the dynamics of inflation expectations.

On top of

Alcoa's

(AA) - Get Report

disappointing sales figures Monday night, retailers

Home Depot

(HD) - Get Report

and

Sears

(SHLD)

opened the day with ugly earnings warnings while homebuilder

D.R. Horton

(DHI) - Get Report

said third-quarter home orders tumbled 47%, forecast a net loss and said market conditions continue to deteriorate.

"We haven't had an auspicious start to earnings," says Art Hogan, chief market strategist at Jefferies & Co. "A lot of high profile names aren't exactly wowing investors, so I wouldn't be surprised to retrace much of last week's move up, which was based on expectations for strong earnings."

In response, the

Dow Jones Industrial Average

fell 1.1%, or 148 points to close at 13,501.70 while the

S&P 500

slid 1.4% to close at 1510.12 and the

Nasdaq Composite

declined 1.2% to close at 2639.16.

Home Depot announced that its fiscal 2007 earnings will decline more than it had anticipated. And its chief executive Frank Blake said, "We look at the overall market and say there's still correction that lies ahead of us," according to news wire reports. Shares gained fractionally however due to the company's announcement that it made a tender offer for 250 million shares of its stock.

Sears slid 10% on news that its second-quarter earnings will not meet Wall Street expectations either, due to weak appliance sales. The S&P Retail Index fell 2.4% on the day as investors fretted the future of the U.S. consumer, despite the stable employment environment and a reaccelerating economy.

In the tortured homebuilding sector, D.R. Horton fell 2% while the Philadelphia Homebuilder Sector Index fell 2.7%.

Meanwhile, bond yields rose Tuesday in a flight-to-quality response to a credit warning by Standard & Poor's and a downgrade by Moody's Investors service of subprime mortgage-related debt, says T.J. Marta, fixed-income strategist at RBC Capital Markets. The yield on the 10-year note fell to 5.04% from 5.16%.

The action by the rating agencies, however belated, weighed on financials, notably

Lehman Brothers

(LEH)

and

Bear Stearns

(BSC)

.

The stock market dived further Tuesday afternoon after Bernanke spoke, though most traders initially felt he was on message, meaning slightly hawkish with not much to say regarding the future of interest rates.

Indeed, the speech seemed tailored to the economics Ph.D.s out there.

Bernanke discussed the relationship of inflation expectations to monetary policy in terms of how they play into forecasting inflation itself and setting monetary policy.

In sum, Bernanke provided an explanation for the mystery of why rising headline inflation, which includes energy and food prices, has not filtered into measures of core inflation, which has declined. But his speech was also perhaps a justification for keeping the fed funds rate at 5.25% even with core inflation moving into the Fed's comfort zone.

The chairman's explanation for the bipolar headline and core inflation is that inflation expectations remain under control. "The extent to which inflation expectations are anchored has first-order implications for the performance of inflation and of the economy more generally," said Bernanke, echoing a recent speech by Fed Governor Richard Mishkin.

Inflation expectations have been anchored, but not "perfectly anchored," he says. Anchored refers to the public's sensitivity to incoming inflation data, he explained. In other words, high food and energy price pressure are unlikely to spill into core inflation as long as the public's expectations for inflation are anchored.

"If inflation expectations started to become unglued in an environment where headline inflation is higher, the Fed would have to disinflate by raising the fed funds rate," says Michael Darda, chief economist at MKM Partners.

By emphasizing expectations, the Fed may be justifying staying on hold despite falling core inflation. Certainly the cry from the markets if core inflation continues to fall into the Fed's so-called comfort zone will be, "We're there, where's the rate cut?" In a way, the Fed moved the target data from core inflation to measures of inflation expectations.

The Fed has outlined a 1% to 2% target range for core inflation. And just two weeks ago, the Fed's favored measure, the core personal consumption expenditures index, slipped to 1.9% on a year-over-year basis. But as core inflation has fallen, the only measures the Fed and the markets have to account for inflation expectations have been moving in the opposite direction.

Most poignantly, risk premiums on inflation-adjusted Treasury bonds have been in a rising trend for most of the year, and currently hover around 240 basis points. In the past decade, the Fed has not cut interest rates unless the TIPS spread has been at 200 basis points or lower, Darda notes.

So as the Fed calendar fills up, watch for "anchored" to be sprinkled into speeches and Bernanke's upcoming testimony to Congress. If earnings season continues on its current path, the stock market too may seem tied to an anchor.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click

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