Inflation fears undermine stocks


The major averages remain under pressure, reflecting inflation worries and continued weakness in financial stocks. Near-term trading, likely to hinge on news regarding June-quarter results and the inflation outlook, could be choppy. Still, with the Dow Theory in the bullish camp and quality stocks available at reasonable valuations, a mostly invested posture seems appropriate. For now, our recommended cash position remains at 15% to 20% of equity portfolios.

Inflation fears
Since peaking May 2 at 13,058.20, the Dow Industrials have lost more than 1,000 points. Nearly half of that drop reflects the declines in the average’s five financial stocks, which have dropped by an average of 26% since May 2. But stocks have declined fairly broadly since June 5, when the Dow Transports, S&P SmallCap 600 Index, and equal-weighted measures of the market peaked.

Weighing on the broad market, among other things, are rising concerns regarding inflation. Based on the U.S. Consumer Price Index, year-over-year inflation in May worsened for the first time in four months, with prices up 4.2% from a year earlier. Excluding volatile food and energy prices, core inflation was 2.3% — above the Federal Reserve’s preferred range of 1.5% to 2%.

So far, argues Fed Chairman Ben Bernanke, underlying inflation and consumers’ long-term inflation expectations do not appear to have become “unmoored.” But Bernanke and other Fed officials have been adamant that they will not allow the Fed’s inflation-fighting credibility to erode, so the Fed may be forced to raise interest rates if rising energy costs lift core inflation much higher.

Perhaps more important, rising food and energy prices are eroding the purchasing power of consumers, forcing cutbacks in discretionary spending. With wage growth sluggish and job growth nonexistent, many worry the latest jump in energy prices will trigger another leg down in consumer spending.

Considering the relatively pessimistic sentiment among investors and the low percentage of NYSE stocks trading above their 200-day moving averages, a near-term bounce in the averages would not be surprising. But recent market action suggests holding 15% to 20% of equity portfolios in cash is prudent for now. Also, finding attractive stocks has become more difficult outside the energy, industrials, and technology sectors — where we are already well represented. For new buying, top picks include Transocean ($148; NYSE: RIG), Manitowoc ($39; NYSE: MTW), and Qualcomm ($49; NASDAQ: QCOM).

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