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Economic muddle sinks stocks

High oil prices and a still-weak financial sector mean the economy - and the markets - face more pain ahead.

By Colin Barr, senior writer
Last Updated: June 26, 2008: 5:19 PM EDT

NEW YORK (Fortune) -- Thursday's stock market selloff reflects a sobering truth: Nine months of strong medicine have failed to cure the credit crisis and left the economy in a weakened state.

The Dow Jones Industrial Average plunged 3% to a 21-month low on Thursday, a day after the Fed held its key interest rate target steady for the first time following nine months of aggressive rate cuts and loans to financial firms. The central bank said it is concerned about rising inflation but is also watching for signs that tepid economic growth will slow further.

The economy is struggling to muddle through a period dominated by two powerful negative forces. The Fed has cut rates by 3.25 percentage points over the past year in an attempt to shore up a weak, undercapitalized banking system swimming in bad loans tied to the housing bubble, and to cushion the loss of consumer spending power tied to falling house prices. But at the same time, consumers and businesses have been laboring under an increasing burden of surging food and fuel prices.

The problem now, from the point of view of Fed chief Ben Bernanke, is that trying to tackle either problem risks exacerbating the other. So the Fed is probably on the sidelines for the balance of the year - which means investors can look forward to more ugly selloffs like Thursday's, which left the Dow down 20% from last fall's all-time high.

"The resilience of the U.S. economy has been remarkable over the past 12 months as the credit crisis spread beyond the subprime mortgage market and oil prices soared," economist Ed Yardeni wrote earlier this week in his daily newsletter. "Unfortunately, there may not be much more that the Fed can do to stimulate economic growth should the resilience of the economy continue to be tested by the credit crisis and oil prices."

Thursday's big losers included truckbuilder Oshkosh (OSK, Fortune 500), which lost a third of its value - costing shareholders some $830 million - after predicting high commodity costs will lead to a third-quarter loss. Other big decliners included automakers General Motors (GM, Fortune 500) and Ford (F, Fortune 500) the latter of which hit a low last seen back in 1985 as high gasoline prices swamp demand for sport utility vehicles. Also hit hard were financial firms Citi (C, Fortune 500) and Merrill Lynch (MER, Fortune 500), which dropped to new lows after analysts said additional mortgage-related losses could lead to more shareholder-diluting stock sales or, in Citi's case, possible dividend cuts. Bank of America, which dropped 7% and now trades at half its year-ago level, said it will cut 7,500 jobs in its purchase of Countrywide.

Soaring oil prices have led to massive losses at U.S. companies in energy-intensive businesses such as auto production and airlines, and have prompted some commentators to call for the Fed to start raising interest rates. But while consumers and many companies would surely benefit from lower food and energy prices, higher interest rates could put further pressure on growth, by reducing demand for goods and services. With May sales at General Motors, for instance, having plunged 30% from a year ago, lower consumer demand is not something struggling companies are looking for.

"The jury still is out as to whether consumer spending is out of the woods," writes Northern Trust economist Paul Kasriel. "The motor vehicle producers would say 'no.'"

Another factor that's hard to overlook is the ill health of the big U.S. banks. Citi dropped 6% Thursday after analysts at Goldman Sachs put the stock on their "conviction sell" list, predicting second-quarter asset writedowns of almost $9 billion. Analysts at Sanford C. Bernstein downgraded Merrill Lynch to sell as well, saying the firm should take $3.5 billion in writedowns in the quarter that's about to end. Analysts at both firms indicated they have been too optimistic up till now in forecasting a financial sector recovery.

"The turnaround in business trends that we had been expecting in the second half of 2008 may not occur as quickly as we should have thought," Goldman Sachs analyst William Tanona said. "We see multiple headwinds."

Headwinds are the least of it, though. As Bernstein analyst Brad Hintz wrote, the problem for big financial companies is that their most profitable businesses, those tied to the fast and furious debt markets of the earlier part of this decade, have essentially ceased to exist. Brokerage firms have shown some ingenuity over the years in exploiting new opportunities in the financial markets, but it will take a while for those to develop.

"We are not recommending investors buy canned goods and bottled water at this point," Hintz writes, adding that low short-term rates and a steeper yield curve will eventually lay the groundwork for a recovery. "But currently the trend lines of Wall Street's high-margin institutional businesses are pointing south."

Unfortunately, those aren't the only trend lines pointing in that direction.  To top of page

Company Price Change % Change
Yahoo! Inc 41.99 1.81 4.50%
Bank of America Corp... 16.56 -0.04 -0.24%
Apple Inc 102.72 0.25 0.24%
The Coca-Cola Co 40.33 -0.35 -0.86%
Microsoft Corp 45.00 0.12 0.27%
Data as of 9:36am ET
Index Last Change % Change
Dow 16,636.23 21.42 0.13%
Nasdaq 4,426.91 7.43 0.17%
S&P 500 1,945.37 4.09 0.21%
Treasuries 2.24 0.03 1.36%
Data as of 9:51am ET
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