Stocks closed out a flat second quarter on a down note yesterday, after the Federal Reserve disappointed investors by indicating it would...

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Stocks closed out a flat second quarter on a down note yesterday, after the Federal Reserve disappointed investors by indicating it would continue its campaign of raising interest rates.

Though yesterday’s quarter-point increase in short-term rates was widely anticipated, “there were some traders who had been hoping the Fed would come out with some language that would indicate an end to the rate hikes,” said Fred Dickson, chief market strategist at D.A. Davidson in Lake Oswego, Ore. “I think that was too optimistic.”

Stocks began tumbling as soon as the Fed’s announcement came out at 11:15 a.m. (Pacific Time). The Dow Jones industrial average lost 99.51 points, ending the day and the quarter at 10,274.97. The Dow, perhaps the most widely tracked market gauge, lost 2.2 percent in the quarter and is down 4.7 percent so far in 2005.

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The S&P 500, a broader measure of the largest U.S. companies, fell 8.52 points yesterday to close at 1,191.33, up less than 1 percent on the quarter but down 1.7 percent on the year. The Nasdaq Composite dropped 11.93 points yesterday, to 2,056.96; it gained 2.9 percent in the quarter but is down 5.5 percent this year.

Rising rates, spiking crude-oil prices and expectations of slower economic growth have weighed on equity markets since last November, market-watchers said. Gains in sectors such as energy, utilities and health care have been offset by declines in raw materials and industrials, which performed strongly in 2004 but are more sensitive to the ups and downs of the economic cycle.

With most economists expecting the economy — and corporate profits — to grow more slowly for the rest of 2005, “the defensive areas and higher-quality issues tend to come to the forefront,” said Don Gher, chief investment officer at Coldstream Capital Management in Bellevue. “People forget that cyclicals are, well, cyclical.”

Paulson Capital was the quarter’s top-performing Northwest stock. The small Portland brokerage firm rose 65.9 percent, with most of that gain coming last month when it named a new chief executive.

At the other extreme, troubled supercomputer maker Cray in Seattle lost 51.4 percent in the quarter, closing yesterday at $1.24. Earlier this week, the company said it would lay off 10 percent of its workers and cut pay to save cash.

The flattening yield curve was behind much of the quarter’s market activity. While the Fed has been steadily pushing up short-term rates for the past year, long-term rates — including those on home loans — have actually fallen. That’s one of the biggest factors behind the continuation of the U.S. housing boom and the strength of the construction industry; construction materials, in fact, was the fourth-biggest gainer among S&P’s industrial sectors in the second quarter.

The top-performing industry, though, was water utilities, part of a broader trend in favor of utility stocks. With bond yields down, Dickson said, risk-averse money has flowed to dividend-paying utilities as a substitute.

Banks and savings-and-loans also have benefited from this rate environment, as they can pay minuscule rates on deposits and lend it out at long-term rates.

“Banks have been money machines for a while now,” said Scott Anderson, senior economist at Wells Fargo in Minneapolis. “But as the [yield] curve flattens out, that model doesn’t work anymore.”

The major stock indices generally hit their lows for the quarter in late April, and until mid-June had been rallying strongly. The S&P 500, for example, rose 7 percent between April 20 and June 17.

But that rally fizzled as oil prices approached and then broke through the $60-a-barrel level on Monday. Even though oil has fallen back somewhat, it’s still expensive enough to have increased costs for many businesses, Anderson said. With the exception of gas stations, those businesses have had limited success in passing on their costs to consumers.

“A lot of companies have had to take the hit, and that has crimped profits and constrained growth,” he said.

Providers of raw industrial materials, such as steel and aluminum, had been among last year’s strongest performers, buoyed by surging demand from China. But China has moved to slow its rampant growth, reducing demand for imports and pushing down commodity prices.

Despite the generally flat market environment, investment bankers steered 53 initial public offerings onto the markets in the quarter, seven more than in the first quarter. But timing, as in so many other things, was everything for would-be IPOs.

So far this year, stocks have rallied twice: from late January to early March and late April to mid-June. Of the 99 newly listed stocks, 64 were brought to market during those rally periods, according to Bloomberg News data.

The only Northwest IPO in the quarter, Zumiez in Everett, has been one of the year’s best performing new issues. Since going public on May 5 at $18 a share, the retailer has soared nearly 62 percent, closing yesterday at $29.15.

Although small-capitalization companies and mid-caps outperformed their larger brethren in the quarter, most observers expect large-caps to regain investors’ favor. Blue-chip profits hold up better in a time of compressing margins, Gher said, and they’re more likely to pay dividends, which gain in significance when investors can’t count on rising stock prices for returns they seek.

Dickson suggested another reason behind the tepid markets: Heat-seeking money is increasingly being invested in real estate rather than stocks, a trend he said extends far beyond U.S. borders.

“We have a tremendous surge of global liquidity that’s trying to find a home, and it’s finding its way into all sorts of assets,” he said. “It’s just like following the dot-com bubble — you put money into the sector that’s moving.”

But with the Fed determined to keep pushing up short-term rates, analysts said, sooner or later long-term rates will follow suit, though Anderson predicted that won’t happen until next year. That alone should take some steam out of the real-estate boom.

And, Dickson said, the higher real-estate prices go, the cheaper stocks look in comparison.

“At some point, savvy speculators are going to recognize that the valuation for stocks is more attractive, and they’re going to move some of that real estate money into stocks,” he said.

Drew DeSilver: 206-464-3145 or ddesilver@seattletimes.com