Rising Rates Will Weaken Stocks

U.S. stocks are expected to fall in the days ahead as rising interest rates undercut the foundation of the market’s latest rally, money managers said.

A jump in bond yields sent U.S. stocks to their biggest two-day drop since March as the past week ended. The yield on the benchmark 30-year Treasury bond jumped to 6.64 percent from a 17-month low of 6.3 percent at the end of July.

The surge in rates - spurred by weak demand for new government debt and concern inflation may be poised to accelerate - rattled confidence in corporate profits. Higher rates threaten to eat into profits by making it more expensive for companies to borrow money and for consumers to finance purchases.

“If long-term interest rates continue to go up, stocks will continue to go down,” said Charles Smith, a money manager at Fort Pitt Capital Group who manages about $102 million.

Some investors said bank shares and other financial companies will suffer the most if bond yields climb further in the coming week. Financial firms’ profits are among the most dependent on low interest rates and vibrant demand for loans.

Friday’s plunge was the biggest for the Dow since June, erasing the gains of the past two weeks. After losing 156.78 on Friday, the Dow Jones Industrial Average ended the week down 162.82 points, or 1.99 percent, at 8031.22. The 30-stock average, which set a closing record of 8259.31 on Wednesday, is still up 24.6 percent in 1997.

Among broader market indexes, the Standard & Poor’s 500 fell 13.60, or 1.42 percent, to 933.54. The Nasdaq Combined Composite closed the week up 4.20, or 0.26 percent, at 1598.53.

Some of the market’s biggest decliners of late were companies that fell short of investors’ earnings expectations.

Coca-Cola Co. dropped after the world’s largest soft drink company said Friday that its third-quarter earnings will increase slightly from last year’s 39 cents a shares, below analysts expectations of 44 cents.

Health maintenance organizations, or HMOs, were the worst performing sector of the S&P 500 Index for the week. On Thursday, United HealthCare Corp. posted a lower-than-forecast profit for the second quarter and warned of sluggish growth for the rest of the year.

The S&P health care composite index slid 6.7 percent for the week. United Healthcare dropped 8.4 percent, Oxford Health Plans Inc. tumbled 11.1 percent, Humana Inc. lost 2.1 percent, and Safeguard Health Enterprises Inc. was off 8.6 percent.

“Companies that disappoint expectations will be taken to the woodshed,” said David Rolfe, chief investment officer at Wedgewood Partners Inc., which manages about $85 million. “Earnings will continue to be strong, but money managers will have to be selective.”

Retail stocks could be a bright spot in the days ahead. Most retailers begin reporting their fiscal second-quarter earnings next week and analysts expect the results to match or beat estimates in many cases, thanks in part to robust sales in July.

“The stronger sales bode well for second-quarter earnings,” said Peter Schaeffer, an analyst at Dillon Read & Co. Wal-Mart Stores Inc., the world’s biggest retailer, J.C. Penney Co. and May Department Stores Co. are among the big retailers expected to report earnings.

Retailers reported the second strongest monthly sales increase of the year on Thursday, thanks to warmer weather that spurred purchases of seasonal goods and a healthy economy that put consumers in a buying mood.

What’s good for retailers may not be good for the stock market, though. When consumers are spending more money and demand for goods escalates, the resulting shortages can spark inflation. On Wednesday, the Commerce Department reports retail sales for July, and a strong number could blast stocks and bonds.

“The market is poised for volatility. If any number is dramatically positive or negative, the market will have a dramatic reaction,” said Daniel Eagan, who manages $3.5 billion for Provident Capital Management.

That volatility has helped investors who bought after big declines this year. So far in 1997, the Dow has lost more than 100 points in a single session nine times, not counting Friday, and in all but one, the market rallied the next day.

For the first time since late April, investors voiced concern that the Federal Reserve may step in to quell inflation by raising interest rates. The central bank next meets on Aug. 19, at which time it will consider whether to boost the federal funds rate above its current 5.5 percent level.

Also next week, the Labor Department will release its consumer and producer price indexes for July, neither of which is expected to show much of an increase. Still, the backward looking nature of the two gauges may do little to soothe concern that growth is too strong to keep inflation at bay for long.

“It isn’t inflation now, it’s the inflation in the future that the Fed worries about,” said A. Gary Shilling, a New Jersey-based manager of more than $100 million in assets.