Stocks Fall on Subprime Fears

Bad news about two Bear Stearns funds spooked investors Wednesday. Fed chairman Bernanke's testimony was also in focus

Major U.S. stock indexes finished lower in active trading Wednesday, though they regained most of their earlier losses in the final hour of trading. Investors sold stocks after some earnings shortfalls and a report that two Bear Stearns Cos. (BSC) subprime hedge funds are essentially worthless. It was a sobering snap back to reality for the market after multiple forays by the blue-chip Dow Jones industrial average above the 14,000 mark on Tuesday.

Investors' mood also soured after testimony by Federal Reserve chairman Ben Bernanke before a House panel. Bernanke said that "core inflation should edge a bit lower, on net, over the remainder of this year and next year," as energy prices level off and labor and product market pressures diminish, reports Standard & Poor's. But he reiterated the view that inflation risk was the Fed's predominant concern.

On Wednesday, the Dow Jones industrial average was lower by 53.33 points, or 0.38%, at 13,918.22 after sustaining triple-digit losses for most of the session. The broader S&P 500 index was down 3.2 points, or 0.21%, to 1,546.17. The tech-heavy Nasdaq Composite index was off 12.8 points, or 0.47%, to 2,699.49.

In his Wednesday testimony, the Fed chief said that the economy should expand at a "moderate pace" the rest of 2007 and "strengthen a bit" next year. Bernanke said the economy has cooled over the past year to a pace "more consistent with a sustainable expansion".

But Bernanke warned that the housing market slowdown may last longer than anticipated and that higher energy and commodity price could spark price increases and push core inflation higher.

Bernanke's extensive focus on the housing sector and consumer safety in his semi-annual testimony before the House Financial Services Committee caught the attention of Wall Street. The central bank chief also outlined Fed activity to combat subprime loan problems.

“Overall, the notation of financial conditions and the numerous comments related to total inflation and inflation expectations provided an overall hawkish tone to Bernanke's report to Congress even as he acknowledged a weaker housing sector,” wrote Lehman Brothers economist Drew Matus on Wednesday.

Bear Stearns wasn't the only Wall Street firm facing subprime worries Wednesday. Action Economics reports that Lehman Brothers (LEH) denied rumors about its subprime exposure as "totally unfounded" after an index that tracks lower-quality subprime debt fell to a record low and concerns about the spread of subprime contagion continued to swirl.

In economic news Wednesday, the U.S. consumer price index posted 0.2% gains for both the overall and core in June, on the heels of increases of 0.7% for the overall index and 0.1% for the core in May. The CPI numbers were exactly in line with most estimates. Energy prices fell 0.5% from May, following a cumulative 14.6% gain since February, with gasoline prices dropping 1.1%. Food costs were up 0.5%, housing costs rose 0.3% with owners' equivalent rents up 0.2%, while apparel prices were down 0.6%.

The CPI report left the 2.2% year-on-year core pace and 2.6% year-on-year headline rate unchanged. The core inflation rates are still oscillating above the Fed's 2% "soft" target, though rates have moderated since then first quarter, but the headline rate is due to pop to the 4% level in October and November even if oil prices stay unchanged, according to Action Economics.

Housing starts bounced 2.3% in June to an annualized rate of 1.47 million, compared with a downward-revised 1.43 million rate for May. Permits fell 7.4% to 1.406 million versus an upward-revised 1.520 million rate in May. The drop in permits was largest since January 1995 and the June figure is below the 1.46 million to 1.63 million range since October, implying a drop in housing starts to new lows around 1.4 million in the third quarter. Action Economics said it now expects 10% rates of decline in residential construction in both the second- and third-quarter GDP reports.

In the energy markets Wednesday, August WTI crude futures rose $1.03 to $75.05 per barrel, while August gasoline surged 9.46 cents to 219.53 cents as a Dept. of Energy report showed energy inventories unexpectedly fell across the board. Analysts were especially surprised at the 2.3 million barrel gasoline decrease, according to S&P MarketScope.

Among stocks in the news Wednesday, Bear Stearns said there was very little value remaining in its two failed hedge funds due to subprime mortgage losses, which re-ignited fears in the market of wider financial damage from the bad loans.

Before the opening bell, JPMorgan Chase & Co. (JPM) reported earnings that exceeded analysts' forecasts but mentioned weakness in its retail banking business and said it increased reserves set aside to cover mortgage losses.

After the market close on Tuesday, Intel Corp. (INTC) reported a 44% leap in second-quarter earnings despite lower chip prices but cited disappointing profit margins.

Yahoo Inc. (YHOO) posted a profit of 11 cents a share, flat from a year ago, despite an 11% rise in revenue. The company lowered its full-year outlook. Standard & Poor's maintained its hold rating, while Bear Stearns kept its outperform rating.

Altria Group (MO) posted earnings of $1.15 a share vs. $1.05 a year ago on a 9.7% rise in net revenue. The consumer products maker lowered its 2007 forecast to $4.05 to $4.10 to reflect 15 cents a share in additional charges for asset impairment and business-exit costs.

Macy's (M) shares gained after a Women's Wear Daily report that KKR is considering a bid for the department-store operator. Sources cited by the report say Kohlberg was partnering with Goldman Sachs (GS) on an offer valued at $52 per Macy's share.

European stock markets finished solidly lower on Wednesday. In London, the FTSE 100 index was down 1.38 % to 6,567.1. Germany's DAX index fell 1.8% to 7,893.61. In Paris, the CAC 40 index was off 1.69% at 5,995.97.

Asian markets traded mostly lower on Wednesday. In Japan, the Nikkei index dropped 1.11% to 18,015.58. In Hong Kong, the Hang Seng index was down 0.93% to 22,8541.92. In China, the Shanghai Composite index climbed 0.87% to 3,930.06.

Treasury Market

Treasury prices rose Wednesday on back of June core CPI that met expectations and a big drop in June building permits. The data caused some covering of short positions initiated in the previous session in the wake of higher-than-expected reading on the June PPI.

The 10-year note rose 10/32 in price to 96-04/32 for a yield of 5.00%. The 30-year bond climbed 15/32 to 94-22/32 for a yield of 5.10%.

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