MarketView for August 19

Summary

Stock prices took a major hit for the second straight day on Tuesday as credit worries hit bank shares and a report showing inflation remains a threat despite slower growth stoked the market's anxiety. Specifically, the producer price index rose at the fastest annual rate in 27 years during July, while core prices that omit volatile food and energy posted their fastest rise since November 2006. That unnerved investors because it puts the Federal Reserve in an increasingly difficult position when it comes to maintaining its policy of low interest rates.

Adding to the Street’s chagrin was the increasing expectation that Fannie Mae and Freddie Mac will likely require a massive government bailout despite the fact tht Freddie Mac had little trouble selling new debt. Yet, despite its implied government guarantee, Freddie's five-year note issue priced at 1.13 percentage points above five-year Treasuries. A similar issue in March priced at a spread of 1.055 percentage points.

Financial stocks were the largest drag on both the Dow Jones industrial average and the S&P 500, with Bank of America and Wells Fargo each down more than 3 percent. Lehman Brothers had another dismal day as its share price fell 13 percent after JPMorgan Securities forecast that the investment bank will take an additional $4 billion in write-downs tied to losses on mortgage-related investments. American International Group after Goldman Sachs cut its price target on the stock to $23 from $30.

Home Depot saw its share price fall 3.7 percent to $25.96 after the company forecast weakness into 2009 as the housing slump continues. Home Depot is a component of the Dow.

On a more positive note, Hewlett-Packard saw its share price rebound in after-hours trading after the company reported a higher quarterly profit and strong sales for its notebook computer and printer business.

During the regular session, sectors sensitive to high oil prices generally weakened. The Airline Index shed 7.8 percent. Oil has declined sharply in recent weeks from a high above $147, but it seems to be consolidating losses in recent days. Specifically, domestic sweet crude for August delivery settled up $1.66 per barrel at $114.53, after briefly touching $116 during morning trading.

The shares of home builders were lower after the Commerce Department said housing starts in July fell 11 percent, the lowest annual rate in more than 17 years. The Dow Jones index of home builders' shares dropped 3.5 percent.

On the NASDAQ, shares of Staples were lower after the office supply chain said tough market conditions hurt quarterly results.

Wholesale Prices Rise Sharply

The Labor Department reported that wholesale prices rose 1.2 percent in July, pushed higher by rising costs for energy, motor vehicles and other products. The increase was the fastest pace in 27 years, according to government data released Tuesday. Core prices, which exclude food and energy, rose 0.7 percent, the largest rise since November 2006. The bad news on wholesale prices followed a report last week that consumer prices shot up by 0.8 percent in July, leaving consumer inflation rising at the fastest pace in 27 years.

The July price pressures did reflect in part the big surge in energy costs during the month that pushed crude oil prices to a record of $147.27 per barrel and sent gasoline pump prices to an all-time high of $4.11 per gallon. Crude oil prices have fallen by more than $30 per barrel since then, raising hopes that the surge in inflation will soon abate.

However, the price spikes in a number of areas seen in July raised concerns that the prolonged surge in energy prices was beginning to show up more broadly throughout the economy. Such a development would put the Federal Reserve in a severe bind. The central bank would like to keep interest rates low to give a boost to the badly lagging economy, but Fed officials may feel pressured to start raising rates in an effort to make sure inflation does not get out of control.

For July, wholesale energy prices jumped by 3.1 percent following a 6 percent gain in June. That increase reflected big jumps in the price of natural gas, home heating oil and liquefied petroleum gas, which offset a 0.2 percent dip in gasoline costs.

Food prices rose by 0.3 percent in July after a 1.5 percent surge in June. Beef prices jumped by 7.4 percent, the largest increase in nearly four years. Milk prices were up by 5 percent, the largest gain in a year, while soft drink prices rose by 2.4 percent, the largest increase in four years.

Excluding energy and food, the 0.7 percent rise in core inflation reflected big gains in the prices of passenger cars and light trucks, pharmaceutical preparations and plastic products.

Fed’s Fisher has it right

Dallas Federal Reserve Bank President Richard Fisher had it right when made the point on Tuesday that Fed policy-makers "have no intention of squandering the bedrock capital of a central bank: the confidence the public places in our hands to keep inflation at bay while we work to bolster economic growth and restore the financial system."

"Until we have a clear sense of what will prevail, monetary policy makers must remain poised to act if slowing growth fails to contain inflationary pressures," Fisher said.

Fisher is a voting member of the Fed's interest-rate setting committee this year and has dissented at every meeting so far in favor either of higher rates, or of less aggressive easing. This has earned him a reputation as one of the most hawkish, or anti-inflation, officials at the U.S. central bank.

Fisher said the Fed had "done its job on the growth front", although he warned the economy would slow to a snail's pace in the second half, if not grind completely to a halt, before a recovery unfolds in 2009 to take it back to trend growth.

"If you were a yachtsman, you would say that we sailed the economy along in a following sea for a long time; now we are navigating force 10 seas. Everyone is battening down the hatches," he said.

He also acknowledged that current market conditions remained very fragile.

"The correction in the housing market has yet to find its bottom. Credit markets remain tempestuous," he said, subtly reinforcing market expectations that the Fed will keep rates on hold in the months ahead.

The Fed has telegraphed its desire to keep rates steady while waiting for credit market strain from massive subprime home loan losses to fade, then take back its policy accommodation to keep inflation at bay as and when it can.

Fisher said this forbearance was a delicate balancing act but should not be mistaken for a gamble with the central bank's hard-won credibility.

Housing Starts Tumble

The Commerce Department reported on Tuesday that the start of construction of new homes and apartments fell in July to the lowest level in more than 17 years as builders broke ground on 965,000 housing units on an annualized basis. That was down from a pace of 1.08 million in June and the weakest showing since March 1991. The latest housing figures continue to show a badly battered housing market, one of the largest problems plaguing the already shaky national economy.

The report showed that construction of single-family homes in July fell by 2.9 percent from the previous month to a pace of 641,000. That was the lowest since January 1991, when the economy also was in distress. New home construction last month was down a sharp 39.2 percent compared with July 2007, illustrating how much ground the housing market has lost in the past year.

Construction of apartments and other multifamily dwellings also fell sharply in July, after a large increase in the previous month due to a change in New York City's building codes. That change, which went into effect July 1, gave a rare lift to overall housing construction in June.

Housing permits in July fell to a rate of 937,000, a 17.7 percent drop from June, but still above analysts' expectations of 925,000. Permits are considered a reliable sign of future activity.

Homebuilders are hoping the housing rescue package approved by Congress last month will boost the dismal real estate sector. The law includes a temporary $7,500 tax credit for first-time homebuyers that essentially works out to a 15-year, interest-free loan.

However, there was one measure of longer-term sentiment that did improve a bit, the measure of builders' sales expectations in six months rose two points to 25.

Higher Earnings at Hewlett-Packard

Hewlett-Packard exceeded Street expectations in an earnings report released after the close of regular trading on Tuesday. In doing so it helped overcome some of the Street’s fears that slowing global economies and a stronger dollar would substantially weaken the world's biggest computer and printer maker. The company also said it expects fourth-quarter earnings also ahead of expectations.

Hewlett-Packard reported net income for the fiscal quarter ending July 31 of $2.5 billion, or 80 cents a share, up from $1.78 billion, or 66 cents per diluted share, in the year-ago quarter. Excluding items, the company reported earnings of 86 cents per share. Revenue increased 10 percent to $28.0 billion. Printer division results were not as had been hoped, but the Street was generally positive on the quarterly report.