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What a Week: Acrophobia

As the Dow hits 12,000, anxiety over the economy and earnings starts to creep into the conversation.
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It was the week of Dow 12,000, barely.

IBM

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and

Google

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roared as

Yahoo!

(YHOO)

and newspapers flailed. Eliot Spitzer scored a victory, and Willy McGuire became history.

When the smoke cleared, the

Dow Jones Industrial Average

was just above the 12,000 mark, which it closed above Thursday for the first time in history.

But Friday's disappointing profit outlook from

Caterpillar

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TheStreet Recommends

killed momentum. Coupled with signs of both inflation and slowing economic conditions earlier in the week, investors were reminded that the market could be running on borrowed time.

"While things look great now, the problem is the direction

in which things are going," says Peter Dunay, chief market strategist with Leeb Capital Management. "Stocks are going up, but earnings growth is slowing and the economy is slowing."

Caterpillar, a manufacturer of heavy machinery and an industrial bellwether, reported a 15% jump in third-quarter earnings. But the firm sharply reduced its full-year profit forecast and said it expects a slowdown in 2007. The Dow component tumbled 14.2% Friday.

On a conference call, Caterpillar's management tried to put a positive spin on its new outlook. Analysts were told next year's slowdown would be a pause -- not the end of a three-year sales surge that has doubled the firm's annual revenue. But skeptics grasped the report as evidence that the slumping housing market will soon be felt throughout the economy, prompting an economic slowdown -- if not a recession -- and the death of an aging bull market.

Still, that's a minority view on Wall Street. According to the latest reading of the Investors Intelligence Advisory Sentiment Index, 52.2% of money managers on Wall Street are bullish, while 30% are bearish and 17.8% expect a market correction in stocks from recent highs. Other sentiment indicators also show rising optimism, as

reported here. While the results aren't so overwhelmingly bullish that contrarians can start shorting everything in sight, they do suggest that conventional wisdom has turned decidedly rosy.

Despite Friday's minor setback, the Dow still managed to extend its winning streak to four weeks in a row. It finished the week up 0.3%, leaving it up 12% year to date. The

S&P 500

-- now up 9.5% for the year -- added 0.2% for the week. The

Nasdaq Composite

finished the week down by 0.6% amid notable weakness in the chip stocks. The Comp is now up 6% for the year.

Earnings Parade and Perp Walk

By Friday morning, 151 companies from the S&P 500 had reported results; 74% of reporting companies have exceeded estimates, and the results are beating expectations by an aggregate of 5%. Wall Street's outlook for earnings growth has climbed to 15.9% for the quarter, up from where expectations were a week ago at 14%, according to Thomson First Call.

Trouble, however, could be brewing. Energy, the sector that has consistently led the S&P in recent years, is expected to slow to a 16% increase in profits in the third quarter. John Butters, analyst with Thomson First Call, says it's likely to suffer a year-over-year decline in the fourth quarter for the first time since 2002.

Also, overall expectations for the fourth quarter have come down over the last week to 11.4% from 11.7% as companies have ratcheted back expectations.

"I wouldn't read too much into that, because it's not unusual," says Butters. "But it is something we'll be keeping an eye on."

For its part, Google remained untouchable, as its 92% earnings surge and 70% revenue gain sailed past Wall Street's expectations. Apple and IBM also outperformed, while Yahoo! disappointed investors with a 37% profit decline and lackluster full-year guidance. The struggles continued for newspaper publishers such as

Dow Jones

(DJ)

,

The New York Times

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and

Tribune

(TRB)

. Shares of

Motorola

(MOT)

also shed 10% after it reported earnings that missed analysts' estimates.

On the economic front, the same market cheerleaders who were once urging investors to focus on core prices to factor out oil prices as they pushed up headline results are suddenly trumpeting noncore results as falling oil prices drag the overall numbers down. This week, crude oil prices continued their slide to nearly a one-year low, ending Friday at $56.82 a barrel.

On Tuesday, the Labor Department said the producer price index dropped 1.3% in September, a steeper decline than anticipated, but the core number advanced 0.6% -- three times Wall Street's forecast. Then on Wednesday, the government said its consumer price index for September was down 0.5%, compared with expectations for a decline of 0.3%. The core index, however, rose 0.2%, in line with estimates.

Inflation hawks were quick to point out that at 2.9% on a year-over-year basis, core CPI remains above the

Federal Reserve's

target range.

"You can't dismiss inflation yet," says Dunay. "The trend says there's still enough inflation out there that we can't say it isn't a worry. It still looks like

former Fed chairman Alan Greenspan held rates way too low for far too long. At some point, one could assume we're going to have to correct that with higher interest rates."

In addition to inflation, signs of slowness persisted as the Fed reported Tuesday that industrial production dropped off more than expected in September, down 0.6%. The Philadelphia Federal Reserve said Thursday that its manufacturing index for October posted an unexpected drop for a second month in a row. It was down 0.7 points, while economists had predicted a gain of 6.5.

Finally, a preliminary ruling against the deposed chief of the

New York Stock Exchange

, Richard Grasso, from a New York Supreme Court judge brought back repressed memories of the corporate scandals that engulfed Wall Street in the early 2000s.

That's not the final ruling in the case, but the headlines served to remind investors that recent calls for reform of runaway compensation practices have largely fallen on deaf ears.

As evidence, one need look no further than the firing of

UnitedHealth

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CEO William McGuire, who became the latest casualty of the options-backdating scandal -- a new cesspool of festering compensation abuse that is slowly oozing across the U.S. financial landscape.

It just goes to show that all good parties eventually come to an end.