Sun, May 21, 2006 page10

• Selloff could signal a gloomy season

  MOOD SHIFT The US Federal Reserve's hint that it may keep raising interest rates, combined with signs of growing inflation, could mark the start of a bear market

  • AFP
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  An ugly week on Wall Street has market watchers pondering whether the sharp selloff in recent sessions is a normal correction, or the start of a more gloomy picture.

  The Dow Jones Industrial Average suffered a 2.1 percent loss to end the week at 11,139.99.

  The tech-heavy NASDAQ composite lost 2.2 percent for the week to 2,193.88 while the broad-market Standard and Poor's 500 gave back 1.8 percent to 1,267.03.

  The mood has shifted from upbeat to pessimistic since a May 10 announcement by the Federal Reserve that it is leaving the door open to additional rate hikes, fueling jitters about inflation and higher interest rates that would dent stock values.

  Heightening concerns in the past week was a report showing a steeper-than-expected increase in inflation at the consumer level.

  Brian Wesbury at First Trust Portfolios said the upsurge in prices caught markets by surprise.

  "This puts the Fed squarely behind the inflation curve, which is clearly spooking the equity markets," he said. "We believe the Fed is beginning to recognize this reality and will lift rates to neutral [between 5.5 and 6.0 percent] in 2006. This would be the best policy for the economy and equities."

  The market is torn between those who see inflation racing out of control, and others who anticipate a cooling economy in the coming months. But some say both may become a problem, creating a "stagflation" scenario reminiscent of the 1970s.

  "In the US, markets are still trying to get comfortable with the notion that they can have residual strength in consumer prices [and other prices], while the economy attempts to move to a slower growth trajectory," said Scotia Bank's Mark Chandler and Carolyn Kwan in a research note.

  "In the near-term, that means shouts of stagflation -- as is almost always the case when inflation and growth are headed in opposite directions," they said.

  Rod Smyth, chief investment strategist at Wachovia Securities, said the economy is showing signs of cooling, but the degree is unclear.

  "We see growing evidence to support our view of a US consumption slowdown and we think this will actually be good news for the medium- to long-term health of global financial markets," Smyth said.

  "We think the critical issue is whether US consumption will slow enough to dampen the current global economic boom and prevent a resurgence of inflation -- in our view the greatest enemy of stock and bond investors. On a longer-term basis, we think it will, but feel the stock market will struggle until the bear market in bonds has run its course. We think this will take several months," they said.

  John Wilson, equity analyst at Morgan Keegan, sees the slump as a buying opportunity.

  "When we get into a correction and investors and traders can't sleep at night because of worrying over being long the market, they tend to sell until they can sleep," he said.

  "Since the market bottom in March 2003, corrections have presented great buying opportunities and we expect this one to be similar," he said.

  Bob Doll, chief investment office at Merrill Lynch, sees some further turmoil ahead.

  "Equity markets may have entered a corrective phase, which we had anticipated would happen at some point in 2006," he said.

  "If a correction does occur, we do not believe it would represent the beginning of a bear market, and expect it should end once the economy goes through its mid-cycle slowdown," he said.

  But in the meantime, Doll said, "financial markets are in for a bumpy period. Volatility will likely stay high until we see some cooling in economic growth, signs of lower inflation, moderation in commodity prices and a restoration in investors confidence in the Fed, which seems to have been lost over the past couple of weeks."

  Bonds got a slight reprieve over the past week.

  The yield on the 10-year US Treasury bond fell back to 5.054 percent from to 5.186 percent a week earlier and that on the 30-year bond dropped to 5.137 percent from 5.298.

  Bond yields and prices move in opposite directions.
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