What a Week: Foul Odor

When the week's market action culminated Friday with a jobs report sprinkled with hints of the hated "s-word," traders were left with little to do but sell.

Stagflation, a period of rising interest rates in a slowing economy, remains a threat to the stock market as a possible hangover after the long period of record-low interest rates in the early part of this decade. Easy credit powered a real estate boom that, with the aid of lower tax rates, gave consumers the spending power to drive economic growth.

But after roughly four years of economic expansion, investors are starting to price in a slowdown, and the slow jobs growth that showed up in Friday's payroll employment report jibed with their concerns. Even worse, stronger-than-expected wage growth played into recent statements from the Federal Reserve about the threat of inflation, and traders were hit with a double-whammy.

The Labor Department said nonfarm payrolls added just 121,000 new jobs in June, short of expectations for about 200,000 jobs; that consensus figure had risen from 160,000 after Wednesday's stronger-than-expected ADP jobs survey. The Labor Department's report paints a picture of an economy that is barely adding enough jobs to keep pace with population growth. May's payrolls were revised upward, but remained weak at 92,000.

In contrast to the slow jobs growth, the government said average hourly earnings rose 0.5%, compared to the 0.1% increase recorded in May. Economists were expecting a tick up to 0.3%. The number ultimately reported gave the market cause for alarm because wage inflation could prompt the Federal Reserve to keep tightening.

In response, the stock market dropped, with the Nasdaq Composite leading the decline, down 25 points, or 1.2%, to 2130. The Dow Jones Industrial Average finished down 135 points, or 1.2%, to 11,091, and the S&P 500 lost 9 points, or 0.7%, to 1265. That left all three indices lower for the week. The Dow lost 60 points, the Nasdaq shed 42 points and the S&P was down 5.

"From 2002 to 2004, I was bullish on stocks because I thought that earnings would be above consensus because things looked like they were going to get stronger," says Subodh Kumar, chief investment strategist with CIBC world markets. "Now, I'm concerned -- not because we're facing recession. I think the momentum peak has come and gone, and we'll soon start to see things like earnings come in weaker than expected."

Indeed, warnings of lower-than-expected second-quarter sales from 3M ( MMM) and AMD ( AMD), as well as disappointing same-store sales growth at Starbucks ( SBUX) contributed to the negativity on Friday.

In the end, it was a bad week for a stock market that recently roared back to life on hopes the Fed might soon pause its tightening campaign. Instead, Friday's session joined a series of recent selloffs that has many investors preparing for a bear market. The turmoil began when the Fed made a more-hawkish-than-expected statement on May 10, which was followed by similar rhetoric from chairman Ben Bernanke and other policymakers. In hindsight, the June 30 FOMC statement may have been an anomaly or misinterpreted by traders who've long wished for an end to the Fed's rate hikes.

"The markets would like to see some clarity in terms of Fed and central bank policy, but I think the indications are that monetary policy is going to be tighter," Kumar says. "Central banks are trying to avoid a situation like the 1970s when the Fed procrastinated on raising rates, and the result was a terrible period of sky-high rates and a weak economy."

Central banks in China and Japan are indicating their policy is going to focus on slowing growth, while the European Central Bank made some hawkish comments regarding inflation this week. The Bank of Japan is expected to raise rates for the first time in six years at its policy meeting next week.

Kumar recently raised the bond weighting in his portfolio for the first time in five years, moving away from the stock market.

"The cyclical areas of the stock market are less interesting to me now," he says. "The question is: Do we move into quality growth stocks, or do we go straight for defensive sectors? I think it's too early for that."

To be sure, Kumar is not all doom and gloom, but he does say the "big dynamic upswing" in stocks that took place between 2002 and 2005 is over. Now he puts fair value on the S&P at 1300 and predicts the equity markets will continue to oscillate around that mark -- moving sideways.

There are reasons for optimism, however. General Motors ( GM), coming out of a nightmarish stretch last year that made "bankruptcy" a household word, is leading the Dow's gains this year. Its shares are up 55% for the year, and it added to those gains Friday when its chairman and chief executive, Richard Wagoner, agreed to explore a potential landmark deal to partner with Nissan and Renault.

Having already made better-than-expected progress on shaving down its bloated cost structure with one of the largest employee buyouts in U.S. corporate history, GM's willingness to explore this deal was welcomed by investors as a sign the automaker is ready to get creative. As one of the largest corporate bond issuers in the world, it was a major concern for the financial markets before there was light shining on its horizons.

Meanwhile, corporate earnings have posted double-digit gains for the past dozen quarters. Consumers have proved resilient amid a chorus of negative predictions, and even the softening housing market has shown signs that it may still have some fight.

James Paulsen, chief investment strategist with Wells Capital Management, says investors have been ignoring the Labor Department's household employment survey to their detriment. Economists have long pointed to payrolls as a more reliable statistic, but Paulsen says the impressively low U.S. unemployment rate of 4.6% is a more accurate reflection of reality.

"The whole world is ignoring the household survey and all the other signs of strength out there," says Paulsen. "We do have some inflation going on. Wages are climbing. That's happening because the job market still has strength, and the payroll survey is an incorrect portrayal of the job market."

He sees gains for stocks and bonds, even as the Fed continues to rein in credit.

But skeptics point to another soft month for retail sales in June, with RetailMetrics LLC reporting that its index tracking same-store sales at over 60 major retailers showed a 2.8% increase for the month, missing its previous forecast that called for a 3% gain. Wal-Mart's ( WMT) 1.2% June same-store sales growth was particularly uninspiring.

On Monday, the government said construction spending dropped unexpectedly during the month by 0.4%. Also, the Institute for Supply Management reported this week that its manufacturing index came in weaker than expected at 53.8; its service index also missed the mark at 57.

But signs of economic slowing are contradicted by the rising cost of raw materials. With crude futures hitting a record of $75.55 a barrel Wednesday, inflationary pressures and the Fed's plan to quash them remain a sticking point.

"Many companies have implemented big price increases to try to pass on higher cost increases," says Margie Patel, portfolio manager with Pioneer Investments. "All the price increases that are coming out of companies that have pretty good businesses say to me that we're going to have continued pressure."

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