Amid Inflation Fears, Stocks Rally

5/2/2011


Strong earnings from railroad, airfreight, and airline companies pushed the Dow Transports to fresh multiyear highs on April 26 and April 27, confirming a similar breakout in the Dow Industrials. The move to new rally highs in both averages signals that the primary trend remains bullish under the Dow Theory, and a recent move to new highs in the widely followed S&P 500 Index adds further evidence of a market uptrend.

Subscribers should maintain a constructive stance toward U.S. stocks, holding a mostly invested portfolio. For now, as a partial hedge, our buy lists have 8.5% to 12% positions in a short-term bond fund.

Inflation risk

In the same week gold prices reached all-time highs, silver prices touched 31-year highs, and the U.S. dollar hit a more than two-year low, the Federal Reserve said "measures of underlying inflation are still subdued." As a result, the Fed said it plans to complete its $600-billion purchase of Treasury bonds as scheduled in June and reiterated expectations that economic conditions are "likely to warrant exceptionally low levels for the federal funds rate for an extended period."

Critics of the Fed blame its loose monetary policy for the slump in the dollar and the jump in prices for energy, food, metals, and other commodities. Many economists are worried that the U.S. may be headed for a surge in inflation. But the Fed says it expects the jump in energy and food prices to be transitory, partly because inflation expectations are stable. Excluding food and energy, core inflation was up 1.2% in the 12 months ended March — below the Fed's informal target of 2.0%.

Much depends on the Fed striking the right balance. A premature boost in interest rates could tip the debt-heavy U.S. economy back into recession. An overly long extension of today's nearly 0% short-term interest rates could lift inflation expectations — and thereby lift actual inflation and long-term bond yields.

Following the Fed announcement on April 27, stocks rallied and bond yields edged higher. But it's worth noting that bond yields are near four-month lows. Yields on 30-year Treasury bonds, highly sensitive to long-term inflation expectations, are below 4.5% — nearly unchanged since early December and below the peak near 4.8% in February.

Conclusion

Investors are right to worry about the risk of inflation. But recent stock-market action suggests the majority money opinion remains bullish, and we are still finding high-quality stocks trading at attractive valuations. For new buying, top picks include IBM ($168; IBM) and MasterCard ($276; MA).


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