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As Dow 11,000 Fades Further, Inflation Colors Assessments

The numbers are likely to be depressing. Both the Dow, which dropped 2.6 percent, and the broader market took a beating the first three months of the year. The Standard & Poor's 500-stock index sank 2.6 percent while the Nasdaq Stock Market index, dominated by technology shares, plunged 8.1 percent.

The Nasdaq's pullback had been widely forecast after a long run-up in tech stocks in 2003 and 2004. Rising interest rates tend to hit young, cash-poor companies the hardest, as the cost of borrowing rises and cuts into the bottom line. The Nasdaq is home to many such companies.

Traders sweat it out at the New York Stock Exchange Thursday. The stock market took a beating in the first quarter. (John Marshall Mantel -- AP)

_____1st Quarter Scorecard_____
Research your mutual funds' performance for the first quarter of 2005:
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_____Mutual Funds Report_____
Raining Dogs (The Washington Post, Apr 3, 2005)
Waiting for Greenspan (The Washington Post, Apr 3, 2005)
Sector ETFs Allow Investing in Trends (The Washington Post, Apr 3, 2005)
_____Funds Q&A_____
Transcript: Washington Post reporter Ben White was online to answer questions about how inflation worries are influencing stock and mutual-fund performance.

Overall, money managers and traders say the main culprits keeping the Dow under 11,000 and pressing on the broader market in the first quarter included rising interests rates, fear of inflation (and the attendant fear of the Fed pushing rates up faster to fight it) and concern that corporate profit growth could slow significantly from the torrid pace of recent years, making stocks appear more expensive.

For the first two months of the year it appeared the Fed could keep its promise to raise rates at a "measured pace" because inflation did not seem a terribly pressing concern. And even as the Fed pushed up its target rate for overnight loans between banks, longer-term rates such as the yield on the 10-year Treasury note, which is closely tied to fixed-rate mortgages, didn't budge.

Things changed in March.

After inflation numbers came in higher than expected, the Fed indicated at its March 22 meeting that it might begin to raise rates more quickly to keep price increases from getting out of control. The yield on the 10-year note responded, finishing the first quarter at 4.49 percent, up from just 3.8 percent a year earlier.

A grim first-quarter profit warning on March 16 from General Motors Corp., a Dow component and the world's biggest carmaker, further darkened the mood on Wall Street. All together, the ebullience of February evaporated in days.

"It's a pretty messy situation now, and people have clearly become fearful," said Jack Caffrey, an equity strategist at J.P. Morgan Private Bank. "A lot of people are playing defense because of rising inflation and fear about how the Fed is going to respond."

But Caffrey said he saw a potential silver lining. He likened the current climate to the same period in 2003 when stocks were sold off heading into first-quarter earnings season only to rise quickly when no major earnings disappointments arose.

"Given the current negativity, I expect we will trade higher if earnings are okay," he said. "The only thing that could damage that case is if inflation ends up being materially worse."

One potential positive is that Wall Street expectations for earnings growth have eased. According to Thomson Financial, analysts expect earnings to grow about 8.2 percent in the first quarter of this year, compared with actual growth of 27.5 percent in the first quarter last year. If companies come in at or above expectations and offer upbeat assessments for the rest of the year, stocks could start rising again and the Dow could once again challenge 11,000.

One wild card, however, could be energy stocks. Some analysts have begun to warn that after a blistering advance fueled by record oil prices, the energy sector could be getting too expensive.

"Near-term, I think the sector is a bit overplayed," said Brett Gallagher, chief of equity trading at Julius Baer in New York. He said that while energy stocks make up about 8 percent of the market, they now account for about 35 percent of the daily volume in exchange-traded funds, investment vehicles favored by active-trading hedge funds. That would tend to indicate a large amount of speculation in the sector.

If oil prices pull back, Gallagher said, shares in the sector could drop. But he added that such a move would present a buying opportunity because the long-term trend for oil prices is higher. So even a temporary drop in energy stock prices probably wouldn't doom the market for the year.

Taking a historic view, Tom McClellan, a market analyst and editor of the McClellan Market Report, noted that the fifth year of a decade is usually a good one for stocks. He also noted that the first three months of the year for stocks tend to be the worst. "Unless you have a phenomenal, massive geopolitical event some other time during the year, you get the low in the first quarter," he said.

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