What a Week: Post-Pause Blues

No action by the Fed prompts concern about a recession rather than the expected rally.
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The long-awaited

Fed

pause came and went like a wedding day, and so did the accompanying rally. With no more anticipation, no more planning, no more wishing for the pause, the hard part started this week -- investing in an environment of slowing growth, rising inflation and neutral monetary policy.

Having priced in the pause after last Friday's soft July payrolls report, the market was already coming off the pre-Fed boil when the central bank held rates steady Tuesday. The market popped momentarily after the Fed announcement, but ended that day on a down note.

Wednesday's reversal confirmed the negative tone for the major averages this week, as Thursday's gains were short-lived relief that a terror plot in London was thwarted. Stocks couldn't hold up Friday, as a strong July retail sales data were deemed a potential sign of more rate hikes vs. confirmation of economic vigor.

Each of the bad-news stories of the week -- oil price spikes, terrorism, a slowing economy, a data-dependent Fed, inflation, the growing options-backdating scandal -- is already somewhat priced in to stocks, says Art Hogan, chief market strategist at Jefferies & Co. "There is bad news all around, but we just don't know how bad."

That being the case, one might even say the market held up fairly well against those headwinds, although major averages suffered their first weekly decline in a month.

The

Dow Jones Industrial Average

fell 0.3% Friday to 11,088.03, down 1.4% on the week, while the

S&P 500

fell 0.4% to 1266.74 Friday, down 1% on the week. The

Nasdaq Composite

fell 0.68% Friday to close at 2057.71 and 1.3% on the week as the midweek excitement over

Cisco's

(CSCO) - Get Report

guidance gave way to new

concerns about options backdating and disappointing results from

Analog Devices

(ADI) - Get Report

, which tumbled 16% Friday.

The Shadow Knows

No sooner did the FOMC utter its decision than investors start fretting that the central bank rubber-stamped the notion of a slowing economy. Meanwhile, the Fed's dovish statement perplexed some investors and economists amid mounting evidence of inflation. Tuesday morning, ahead of the FOMC announcement, the Labor Department reported that productivity growth slowed to a 1.1% gain in the second quarter but that unit labor costs accelerated in the second quarter, growing by 4.2%.

Some economists were disappointed that the Fed paused, but more disappointed that the Fed is insistently relying on a slowing economy to dampen inflation.

"Although this optimistic outlook is possible, experience suggests that it is unlikely," Martin Feldstein, economics professor at Harvard and ex-chairman of the Council of Economic Advisers under President Reagan, wrote in

The Wall Street Journal

. "A mild slowing of economic growth is generally not sufficient to reverse rising inflation."

Mickey Levy, a member of the Shadow Open Market Committee, agrees. The SOMC was created in 1973 by a group of economists to meet and evaluate the policy decisions of the FOMC. According to Levy, at this moment in time the SOMC would say: "Inflation is above the acceptable range. The risk is that it is going to rise further, and most importantly, we would disagree with the Fed's notion that a moderation in real growth will lower inflation on a timely basis."

The debate, therefore, is about how bad the economy will get. To look at the stock market this week, the safe bet would be on the weaker side.

One economic proxy -- the Dow Jones Transportation Index -- declined 1.8%, as investors shifted to defensive sectors to protect against slowing growth.

FedEx

(FDX) - Get Report

declined 1.8% Friday and 5.8% on the week.

Among other deep cyclicals,

Caterpillar

(CAT) - Get Report

fell 2% Friday and 8.3% on the week, while

U.S. Steel

(X) - Get Report

fell 5% Friday and 4.9% on the week.

Alcoa

(AA) - Get Report

fell 2.4% Friday, 4.5% on the week.

Meanwhile, defensive stocks such as

Kraft Foods

(KFT)

and

General Mills

(GIS) - Get Report

gained on the week.

While a slowdown in housing is under way, reconfirmed this week by

Toll Brothers'

(TOL) - Get Report

guidance, deflating real estate prices aren't cutting into the consumer's pocketbook as much as expected. While mortgage refinancing is down 73% from its peak in mid-2003, the "tendency has been to overstate the importance of the refinancing boom" on spending behavior, says John Lonski, chief economist at Moody's Investors Service.

"The consumer is not dead," agrees Brian Wesbury, chief economist at First Trust Advisors, adding that Friday's retail sales data could drive up third-quarter GDP.

Retail sales in July surged 1.4% for the month after falling 0.4% in June, 1% excluding autos. And autos fared well in July, too, gaining 3.1%, after falling 2.5% in June; economists expected a 0.8% increase. Year-over-year, retail sales excluding autos is growing at a 9% rate, the fastest pace in at least 15 years, says Wesbury.

Meanwhile, retailers such as

Kohl's

(KSS) - Get Report

,

Urban Outfitters

(URBN) - Get Report

and

JC Penney

(JCP) - Get Report

reported solid earnings this week, and shares responded.

The bond market continued to reflect its bet on a weak economy, but yields edged higher this week after the Fed paused. The 30-year Treasury bond yielded 5.10% Friday after dipping to 4.99% a week ago. The 10-year note yielded 4.97% Friday, up from 4.9% last week, while the five-year ended the week yielding 4.91%, up from 4.83%, and the two-year climbed to 4.97% from 4.91% last Friday.

Oil had a wild ride this week as well, whipsawed by Monday's news about

BP's

(BP) - Get Report

Alaskan pipeline interruption, the Israeli conflict with Hezbollah and terror fears. Oil ended the week at $74.50 per barrel after jumping to over $77 per barrel intraday Monday.

The week ahead brings the next consumer price index reading, and perhaps a tipping point for the markets. Consensus estimates put year-over-year CPI at 2.8%. But if it tops 3%, "look out below," says Jefferies' Hogan.

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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