International politics overshadowed the economic stories this week, even though the data that streamed in had high stakes attached.

After posting strong gains last week, the major indices floundered through the final five days of the first quarter and ended in the red. The

Dow Jones Industrial Average

finished the week down 1% to close at 12,354.35. The

S&P 500

followed up on its best week in four years by sliding 1% to close at 1420.86. And the

Nasdaq Composite

dropped 1.4% over the five days to end at 2421.64.

For the quarter, the S&P 500 and the Nasdaq eked out 0.1% and 0.2% gains, respectively, while the Dow slipped 0.9%.

Traders reported that testimony by

Federal Reserve

Chairman Ben Bernanke to the Joint Economic Committee this week took a back seat to the escalating conflict in Iran. And while Friday's Chicago Purchasing Managers Index, personal income, spending and inflation data surpassed analysts' expectations, traders responded more to protectionist measures imposed by the Bush administration on China and rumors about war games in the Persian Gulf.

"All this

data has been overshadowed by geopolitical developments," says Joe Brusuelas, chief economist at IDEAglobal.

Meanwhile, oil prices continued their always-unwelcome gains. Crude spiked another 5.6% in the week after rising 8.9% last week. A barrel of light, sweet crude closed Friday at $65.87.

The week's economic data meshed with more profit warnings, a Justice Department probe into homebuilder

Beazer Homes

(BZH) - Get Report

and news that

Dell

(DELL) - Get Report

uncovered misconduct in an investigation into its accounting, leaving investors with a rather bad taste.

"We've had a really big escalation in worries," says James Paulsen, chief investment strategist at Wells Capital Management. "Most of the month, the reports have been to the weaker side, escalating fears about the economy."

Datawise this week, new-home sales and durable goods orders were weak, underscoring the Federal Reserve and Bernanke's twin concerns about the downside risks to the economy: housing and weak business spending.

Fourth-quarter gross domestic product was revised modestly upward to 2.5% from its prior 2.2% estimate, but there wasn't much to get excited about. Investment in capital equipment was weaker than prior estimates, and profits were revised lower.

Friday, the Chicago PMI read 61.7, much higher than expectations of a reading of 49.5, and personal income and spending each jumped 0.6% in February. But the Fed's preferred measure of inflation, the core personal consumption expenditures index, rose 0.3%, which brings year-over-year inflation back to its recent 2.4% peak.

In his testimony, Bernanke ratcheted up the worry quotient about growth, but the data suggest his insistence in Wednesday's testimony that inflation is still the Fed's key concern could soon be tested.

Bernanke was forceful in his attempt to clarify that the Fed's policy stance has not moved to neutral despite confusion last week over the Federal Open Market Committee's removal of its boilerplate "tightening bias."

Perhaps the chairman was responding to skeptics, or vigilantes, in the bond market, who continued to trade out of long-term Treasury bonds and into short-term notes -- steepening the yield curve.

The two-year Treasury note yield fell to 4.58% from 4.61% last Friday, as the 10-year yield jumped to 4.64% from 4.61%, and the yield on the 30-year bond rose to 4.84% from 4.80%.

"Neutral policy is one where risks are weighted equally," said Bernanke in the question-and-answer period of his testimony this week. But he added that in the Fed's view, "inflation risks are predominant," and "we have not shifted away from an inflation bias." In the end, Bernanke summed up, "We're looking for a bit more flexibility given the uncertainties" that have arisen.

One thing is certain: Inflation has not moderated with the slower economy.

Nor has the tight labor market quieted down. Jobless claims were lower in the week, and investors and economists honed in on the connection between business investment, profits and labor -- or, as the Fed refers to it, resource utilization. Bernanke noted in his testimony that if labor costs continue to rise, productivity necessarily has to keep up so that companies don't just pass those costs through to consumer prices. And if consumer demand slips, those costs will quickly eat through profit margins.

"I think we have a productivity problem," says Bruseulas. "If firms are hiring extra workers to meet demand, they can't squeeze more out of that worker without spending to give them the state-of-the-art tools to do so."

Wall Street is already expecting a dramatic slowdown in the pace of corporate profit growth. After 14 quarters of double-digit earnings rises, analysts expect first-quarter profits to grow around 4% to 6%.

First-quarter earnings season doesn't really kick off until April 10, when

Alcoa

(AA) - Get Report

reports, but warnings are starting to multiply.

Motorola

(MOT)

and

Halliburton

(HAL) - Get Report

surprised investors last week, while

RF Micro Devices

(RFMD)

,

ATMI

(ATMI)

,

Lennar

(LEN) - Get Report

, and

Nabors Industries

(NBR) - Get Report

provided this week's gloomy reports or guidance.

The cyclical parts of the market fared poorly on the week amid the economic angst. The Dow Jones Transportation Average slipped 3.3%, while the Morgan Stanley Cyclical Index fell 1%. The Standard & Poor's Retail Index declined 2.2%.

Monday brings the Institute for Supply Management's nonmanufacturing index, which analysts expect to come in just north of 50 at 51. If it's lower, that means contraction in that part of the economy, and investors can expect the market to feel the jolt. But next week's biggest data point, March nonfarm payrolls, falls on Good Friday, a stock market holiday. That may be a bit of a relief to traders in this jittery environment.

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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