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Traders acted like yesterday was the last day of exams and today was the first day of summer vacation, filled with possibility.

The stock market rallied sharply Thursday, but investors should beware -- just because inflation starts to feel normal, that doesn't mean inflation isn't dangerous.

Federal Reserve

officials have offered an unceasing stream of hawkish rhetoric during the past few weeks. As a result, investors are now comfortable with the idea that inflation is at the "high end of the Fed's comfort zone." The phrase rolls off the tongue like a collection of syllables with less punch every time.

Any concerns about the report Wednesday of a third consecutive 0.3% increase in the core consumer price index quickly faded, and stocks surged late, laying the groundwork for the major averages to soar Thursday. Comforting words from Fed Chairman Ben Bernanke helped spur a nearly 200-point rally in the

Dow Jones Industrial Average

, testifying to the market's newfound tolerance for higher inflation.

Of course, as with every sharp market turn, several factors worked together to generate the session's outsized gains. Essentially, stagflation fears that had begun creeping into the minds of some investors were allayed by a combination of Bernanke, stout manufacturing data and a drop in jobless claims.

The reports indicated that growth isn't hitting the skids too hard. The Fed chairman, meanwhile, reassured the markets that inflation's bark is worse than its bite this time around, and that while high energy and commodities prices have trickled into price gauges, the 1970s are not about to be repeated.

Keeping Credibility

For the day, the Dow gained 1.83% to 11,015.19, and the

S&P 500

advanced 2.12% to 1,256.16. The beleaguered

Nasdaq Composite

rallied 2.79% to 2,144.15 as 93% of its total volume was traded to the upside and 77% of its stocks finished higher. On the

New York Stock Exchange

, 78% of its stocks climbed.

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The market saw Bernanke as cool, calm and collected during his latest speech. His remarks that the Fed's credibility is important seemed like an explanation for his harsh hammering on inflation last week. Perhaps he feels his credibility is back.

"As I said recently, now is not the time to short Ben Bernanke," Miller Tabak's chief bond market strategist Tony Crescenzi wrote in a column for


. He added that Donald Kohn's arrival as Fed vice chairman and Hank Paulson's appointment as Treasury secretary will help the central bank's chief be as effective as possible. "Bernanke is likely to shine much better in the second half of the year than in the first half," Crescenzi contended.

But like those optimistic graduation speeches when the weather is warm, the folks are well-dressed and the hopes are high, Bernanke and inflation can seem pretty acceptable when stocks are up 200 points after weeks of painful losses.

Bernanke's communication skills aside, rates are likely to go higher, and that may crimp the markets down the road. The bond market has reacted accordingly, selling off as the likelihood grows that fed funds will go past 5.25%. The fed funds futures market has fully priced in a June rate hike to 5.25%, and it shows a near consensus that short-term rates will go to 5.5% by the end of the year. The 10-year Treasury yielded 5.10% late Thursday, but the curve is still inverted. The two-year Treasury was yielding 5.14%.

Bottom Wishing

Hedge funds were partly responsible for ensuring the market's bounce-back was intense, just as they provided fuel for the down days of May and early June. However, hedge funds can't sustain a rally or a downturn forever. Technical analysis helps traders find a bottom, but many technicians are cautious about calling the last two days anything but a short-term recovery.

Alex Grace, who trades for himself and sells his research to hedge fund clients with more than $20 billion in assets under management, went long the S&P futures at the end of Wednesday, reiterated that he'd be long those futures Thursday morning and then headed to the golf course.

"This was a textbook low in the stock market," says Grace, adding that virtually every technical model he looks at, sentiment and oversold conditions among others, was signaling a rally. Grace says the Dow Transports may be a good leading indicator. That was the only index to reach an all-time high in May, but it didn't trip its 200-day moving average in the downturn, and its gains were big Thursday. The index rose 3.76% to end at 4638.92.

Indeed, sentiment indicators, aside from anecdotal comments about bear markets by fund managers and talking heads, did indicate a trough in bullishness earlier this week. MarketVane measured a two-year low of bullish views on Tuesday. The American Association of Individual Investors' sentiment survey read 55% bearish as of Wednesday -- the highest reading since February 2003.

"The market is like a rubber band you can only stretch so far," says Rich Ishida, chief technical analyst at MarketVane.

Suffice it to say, one day, or even two, doesn't make a trend. Louise Yamada, a technical analyst and founder of her own research shop, Louise Yamada Technical Research Advisors, warns that when rallies are as strong as Thursday's, people sell into the strength.

"We would be inclined to consider this a temporary rally, not necessarily the end of the corrective action," says Yamada. She added that short-covering as part of Friday's expiration of derivative contracts, called "quadruple-witching," may also have lent to the turnaround.

"The worst thing that can happen is we run things up again," says Yamada. Well, not necessarily for Grace and the hedge funds.

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


to send her an email.