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What a Week: Stress Test

Though triple-digit gains in the Dow do make nice headlines, they don't make for signs of a solid stock market bottom.

Stability does, and by most accounts, the stock market steadied this week as investors gained confidence that the economy isn't hitting an iceberg. The anxiety was further quelled by strong economic reports, allowing the industrial and energy groups to forge to the head of the pack.

The ultimate realization was that huge corrections in several assets didn't cause the sky to fall. "This was a wonderful midcycle stress test," says James Paulsen, chief investment strategist at Wells Capital Management. "The global economy passed with flying colors. We reduced all asset prices and nothing blew up. No emerging economy defaulted, no financial institution fell apart, no hedge fund blew up, no mortgage company went under."

For the week, the major U.S. stock market indices pulled back slightly. The Dow Jones Industrial Average fell 0.23% on the week, and 0.27% on Friday to close at 10,989.09. The S&P 500 lost 0.09% on the day and 0.56% for the week to 1244.50, and the Nasdaq dropped 0.07% for the last day of the week and 0.39% over the five sessions to end at 2121.47.

Meanwhile, the Dow Jones Transports Average gained 2.9% on the week to 4773.23. It was the only index to reach an all-time high in May at 4998.95, and it was also the lone major index not to break through a 200-day moving average in the market's swoon. The measure, however, is still down 4.5% from its high.

One of the components of the Dow transports, FedEx (FDX) played a key role in the rebound in confidence about the economy. After the company reported 27% growth in earnings year over year on Wednesday, FedEx's chief executive said that the global economy is strong. The company's stock rose 5.35% for the week. That same day, Morgan Stanley (MS) issued its own solid earnings report, helping to fuel the stock market's best session of the five.

The energy sector's exchange-traded funds posted sound results, but Friday was responsible for a good part of the gains, owing largely to Anadarko Petroleum's (APC) announcement that it will buy Kerr-McGee (KMG) and Western Gas Resources (WGR) for more than $21 billion.

Mary Ann Bartels, chief U.S. market analyst at Merrill Lynch, says that while the market may have stabilized, it's not necessarily on firm footing. She believes there's still a 15% to 20% correction in store for the stock market before it rallies into the end of the year and 2007.

In the meantime, the week's data points signaled an economy that higher rates can't topple. Housing might be cooling but it isn't a bursting bubble, initial jobless claims didn't suggest a massive employment slowdown, and even though durable goods orders were lower, the main culprit was a drop in airline orders. Nontransportation orders rose 0.7% in May, beating the 0.6% increase that economists predicted.

If the economy remains strong, the Federal Reserve will believe it has the flexibility to increase rates to fight inflation beyond the June meeting. Economists are starting to predict a fed funds rate reaching at least 5.5% by the end of the year, and some have even 6% on their radar screens.

"We think the presence of persistently elevated headline inflation (a threat to "contained" inflation expectations), core inflation trending slightly above the Fed's comfort zone, against a backdrop of reasonably satisfactory economic performance, should eventually prompt the Fed to take the funds rate to 6% by the middle of next year, if not sooner," Neil Soss, chief economist at Credit Suisse, wrote in a research report.

Inflation will no doubt be part of the conversation when the Federal Open Market Committee meets next week, but the central bank's policymakers also are likely to note the resilience of the economy.

Away from stocks, the yield on the 10-year Treasury note jumped to 5.22% Friday, up 10 basis points from last week's 5.12% yield. The curve is still mildly inverted, with the two-year Treasury yielding 5.25%, up from 5.15% last Friday. Also, the dollar was up sharply, gaining 1% against the euro to finish the week at $1.2506, and climbing 1.27% vs. the yen to 116.56.

Elsewhere, volatility was down, suggesting some calm has returned to the markets. The CBOE Volatility Index, which indicates perceived risk in the market, peaked around 23 on June 13, and it closed Friday at 15.89. For the week, the VIX was down 7.8%.

Stress levels surely will be tested again, especially with the FOMC meeting just days away. Until then, the market will probably keep running on the relatively steady treadmill.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click here to send her an email.

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