What a Week: Slippery Slope for Shares

Wal-Mart's warning and the Merck verdict keep stocks down, where one guru says they'll stay.
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After a week when crude oil prices dipped and major stock averages fell modestly, its tempting to think the market is just in the midst of the dog days of summer, characterized by low volumes and directionless trading.

But important shifts were taking place below the surface this week. For a start, although few market observers have pointed it out so far, the stock market is now in a declining trend, one that began in early August.

This week also brought shifts in market psychology. After brushing off the impact of surging crude oil prices on the economy and profits for months, investors received tangible evidence that soaring gasoline prices are taking a toll on profits.

That evidence came from

Wal-Mart

(WMT) - Get Report

on Tuesday, leading the

Dow Jones Industrial Average

to plunge 120 points that day.

Unable to fully recover from that decline, the blue-chip average fell 0.4% for the week, while the

S&P 500

fell 0.8% and the

Nasdaq Composite

lost 0.9%.

Further cause for concern came as key inflation reports for July showed producer prices were rising much faster than consumer prices, signaling that profit margins are getting squeezed.

That may help explain why bond yields, which had risen sharply through July amid signs of robust economic growth, have since fallen back. As its price rose, the yield of the benchmark 10-year bond finished the week at 4.21%, compared with 4.24% last Friday and 4.39% two weeks ago. If oil's toll on the economy becomes more pronounced, inflation won't be the worry, growth will; a slowing economy with muted inflation is a bullish combination for Treasuries.

On Friday, crude prices gained more than $2 to settle at $65.35, ending the week down 2.3%. Crude's rebound, together with a 7.7% decline in

Merck

(MRK) - Get Report

following a

jury verdict against the drugmaker, helped erased what would have been a modest weekly gain for the Dow.

On Friday, the Dow held on to a gain of 4.3 points, or 0.04%, to finish the week at 10,559.23. The S&P 500 was up 0.69 points, or 0.1%, at 1219.71, while the Nasdaq lost 0.52 points, or 0.02%, to 2135.56.

Tops Are In

This week's action was really a continuation of the downturn the market's began in early August. Aug. 3, to be precise, was when the S&P 500 hit 1245.03. That's an important number to remember, because according to market guru Woody Dorsey, that will be the high for the year for the broad index.

"That was the print," says the founder of Market Semiotics.

Ditto for the other main stock averages, Dorsey says. The Nasdaq topped out at a four-year high of 2218.15 on Aug. 2. As for the Dow, its recent top was at 10,705 on July 28, although its high for the year was at 10,940 on March 4.

Since these recent tops, the indices have been falling back, mostly at a snail's pace -- coinciding, once again, with the

predictions Dorsey made previously. The S&P 500 has fallen 25 points, or 2%, the Nasdaq has given back 83 points, or 3.7%, and the Dow has fallen 145 points, or 1.3%.

And things are about to get worse from here.

Using his trademark blend of research into the market's technical, fundamental and psychological factors, Dorsey says that after rallying for about three years, the market is now ready for a prolonged downside. The economy and profits are poised to slow down amid rising interest rates, slowing home price appreciation and the surging price of oil, he says.

After most investors return from vacation and volumes pick up, selling will accelerate in September and through October, Dorsey predicts. There will then be a short rallying reprieve in November before the downtrend resumes. Next year looks ugly.

"There has been a perceptual shift that oil is a problem for the economy. All crude has to do is to hang around these levels, and even if it came back down to the $50s, the perception is now that it's a problem," Dorsey says.

Last week, economic reports showed surging energy prices had helped widen the U.S. trade deficit in June, lifted import prices in July and dampened consumer confidence in August.

Wal-Mart's warning, together with disappointing second-quarter earnings and outlooks from other retailers such as

Gap

(GPS) - Get Report

,

Limited Brands

(LTD)

and

Hot Topic

(HOTT)

this week only served to reinforce that perception.

There are other concerns. Since the London bombings in early July, which spurred a market rebound throughout the month, terrorism is weighing on sentiment, especially as threats in Saudi Arabia link the phenomenon directly to crude oil prices.

The real thorn will come when all these negatives come together, starting with waning consumer confidence. "People have been sitting around this summer, thinking that real estate isn't going to last much longer, energy prices are going up, the war on terrorism is a failure, and they're just not feeling as good about things," Dorsey says.

The downside in equities, which Dorsey predicts in the fall, will also further act to dampen consumer confidence.

Is there anywhere for stock investors to hide? Not really. "There has been a lot of delusion about the market's performance this year, and now the market has used a lot of ammunition, which is pretty negative," he says.

The credit markets, meanwhile, still have to figure out what to make of oil's risk to growth vs. its inflation implications before they become a good bet, Dorsey believes.

Then there's oil. Barring the unforeseen, Dorsey doesn't expect huge moves in crude oil prices in the short term. But he predicts the "black gold" will remain in a bull market until at least 2009.

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 appreciates your feedback;

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