U.S. service sector shrinks for the first time in 5 years

NEW YORK -- Lingering hopes that the U.S. economy might avert a recession withered Tuesday after the nation's service sector -- its banks, travel companies, contractors and stores, among others -- shrank for the first time in five years.

It was unwelcome news for many investors, who were beginning to believe that the Federal Reserve might engineer a way out of the worst economic slowdown since 1991. Stocks tumbled, with the Dow Jones industrial average losing 370 points, its biggest point drop since August.

Much of the talk was not about whether there would be a recession, but about how bad it might be.

"The number's so terrible it's almost beyond belief, especially among the optimists," said Scott Anderson, senior economist at Wells Fargo & Co. "I think the writing's on the wall. More and more economists are talking about recession, and whether it'll be a severe or mild one."

The January reading from the Institute of Supply Management "was about as big a shock as you can probably get," said Joel Naroff, chief economist at Commerce Bancorp.

Anderson said he believes January may end up being the official start of a recession. Many businesses already suspect as much.

Moving company Allied Van Lines filed for bankruptcy Tuesday, saying it had fallen victim to the downturn in the housing market and its own heavy debt load. Charming Shoppes Inc. -- which runs the Petite Sophisticate and Lane Bryant clothing stores -- said it would cut 200 jobs and close 150 stores.

Stocks of rental car companies plunged Monday after Dollar Thrifty Automotive Group Inc. slashed its 2007 earnings guidance. The company said it sees weak demand in the travel market and soft used-car sales.

Ryan Kaminski, who runs a Mexican restaurant in Sarasota, Fla., said the squeeze he has felt as both a business owner and a consumer since last summer is growing worse. The restaurant's traffic started thinning out last summer, pulling 2007 sales down 10 percent from a year earlier, and so far this year sales are down 15 percent from a year ago.

"I used to be able to find a person from any trade -- carpenters, electricians, plumbers -- in the restaurant every day," he said. "Since the housing market crashed, it's just dried up. Those type of customers are just gone."

Kaminski, 31, said he and his wife don't spend much anymore either. "We've cut out eating out and we didn't go on vacation last year," he said. "It's getting bad."

In the tourism sector, water park operator Great Wolf Resorts Inc. is seeing a drop in business at its resorts in Traverse City, Mich., and Sandusky, Ohio -- two areas where jobs are dependent on the sagging auto industry, said the company's chief executive, John Emery.

Business is up slightly overall for the Madison, Wis.-based operator of 10 resorts. But at the Rust Belt parks, families are cutting their spending by 2 percent to 4 percent. "Those are tough markets for families for right now," Emery said.

Executives surveyed for the service sector report by the Institute for Supply Management fretted over the economy, high oil prices, the falling stock market, lower customer demand, stiffer competition and sluggish sales, said Anthony Nieves, chairman of the trade group's non-manufacturing business survey committee.

The ISM's new composite index measuring the health of the service sector was 44.6 in January, below the level of 50 that indicates expansion. The group's measure of non-manufacturing business activity fell to 41.9 in January from a revised reading of 54.4 in December -- its largest drop ever. Economists surveyed by Thomson Financial/IFR had expected a slight slowdown but had still forecast growth, with a median estimate of 53.

The last time the ISM reported that the service sector shrank -- that is, registered less than 50 -- was March 2003.

"I think it will be tipping plenty of people over the edge" in convincing economists that the U.S. is in a recession, said Nigel Gault, chief U.S. economist at Global Insight.

Gault said that in March 2001, the beginning of the last recession, the index had a break-even reading of 50. And during that recession, the index hung around 48 or 49 -- several points higher than January's reading.

"This is an absolute collapse of this index," he said.

Two measures that fell were those for new orders and employment, and that could signal more trouble ahead. New orders fell to 43.5 while employment fell to 43.9. The drop in employment is especially troubling, because the service sector has been the overall economy's engine of job growth for months.

Factories eliminated 28,000 jobs in January and have cut 269,000 jobs over the past 12 months, the government reported last week. The economy as a whole lost 17,000 jobs last month, which was the first nationwide loss of jobs since August 2003.

The financial services industry, part of the wider service economy, has been especially hard hit by falling home prices, mortgage defaults, and the devaluation of mortgage-backed investments.

After writing down their portfolios and putting money in reserve to prepare for further losses, banks, mortgage lenders and brokerages are now strapped for cash and have pared their payrolls to cut costs.

Challenger, Gray & Christmas Inc., a placement consulting firm, said companies announced 69 percent more job cuts in January than in December, and about 21 percent of those were in the financial sector. According to the firm, the financial sector eliminated more than 153,000 jobs in 2007, a record amount.