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No Escaping the Fed Fears

The thinking Monday is that the central bank has another reason to worry about inflation.
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Updated from Oct. 3

Investors started the fourth quarter with the same lack of conviction that has characterized the market all year.

After posting early gains Monday, stocks were pressured following a report confirming the

Federal Reserve's

prediction that even after Hurricane Katrina, inflation risks appear to be outweighing the chance that economic growth will be impaired.

The markets reflected this no so rosy but not completely bearish outlook. Government bonds fell, but stocks ended mixed as the

Nasdaq Composite

advanced slightly.

The Institute for Supply Management said its manufacturing index jumped to 59.4 in September from 53.6 in August. That was well above expectations for the index to dip to 52.0. One key inflation guage in the ISM report was particularly notable: The survey's prices-paid index skyrocketed to 78 from 62.5.


The ISM report gives a green light for the Fed to continue to tighten on Nov. 1 and

signals that any Fed pause will tend to happen later rather than sooner," says Michael Gregory, an interest rate strategist at BMO Nesbitt Burns.

Still, many investors are eager to put money at work, and there's increasing chatter about a fourth-quarter rally in stocks. Helping the bullish case, the price of crude oil dropped 74 cents to $65.50 a barrel on Nymex.

Merger news helped fuel buying interest early in the day, especially in the tech arena.


(SYMC) - Get Free Report

said it will acquire information technology company



for $209 million.



(GOOG) - Get Free Report

was higher on word that it plans a collaboration with

Sun Microsystems

(SUNW) - Get Free Report


The Nasdaq gained 3.74 points, or 0.17%, to 2155.43.

Outside the tech space, stocks dependent on consumer spending also saw increased buying interest.


(MO) - Get Free Report

, for one, helped prevent wider losses for the

Dow Jones Industrial Average

. The index finished down 33.22 points, or 0.31%, at 10,535.48. While that was well off a pre-ISM report high of 10,608, it was above the intraday low 10,523.63.


(WMT) - Get Free Report

also gained after saying its September same-store-sales would likely be at the higher end of its target range. Even

General Motors

(GM) - Get Free Report

, which said sales fell sharply in September, still eked out a gain, a story that was repeated at


(F) - Get Free Report


A modestly bullish bias was also visible in market technicals. Advancing issues beat declining stocks 17 to 15 on the

New York Stock Exchange

and 16 to 13 on the Nasdaq.

Rising inflation concerns were clearly on display in bond market action Monday. The benchmark 10-year Treasury fell 16/32 in price, while its yield, which moves inversely to price and reflects market expectations of inflation, rose to 4.39%.

To longer-term strategists, such as Rich Bernstein at Merrill Lynch, the higher bond yields signal that cash will outperform equities going forward. The strategist raised his cash allocation and lightened up on stocks in August, for the first time in two years. While he might be correct in the longer run, Bernstein's portfolio allocation might have missed September's gains in stocks.

According to other strategists, like Richard Berner at Morgan Stanley, stocks could be poised for more short-term gains. With inflation now the pet anxiety for the bears, there's room for contrarian investors to play against the concerns about just how stretched consumers may be.

The bearish case for consumption has been building, especially as consumer confidence plunged after Katrina (which was followed shortly thereafter by Hurricane Rita) in September, and investors are increasingly concerned about more to come amid soaring energy prices, rising interest rates and questions about the housing market.

"With investor gloom surrounding everything consumer-related, ranging from retail stocks to those of lenders, a little good news may go a long way in the other direction," Berner says.

Though admitting that many pressures are now assailing the consumer, Bernstein believes "underlying" job and income growth should continue to improve and that "any relief on energy prices would help consumers significantly."

Bernstein, like the Fed, believes the effects from damage along the Gulf Coast will prove transitory, and once that realization sets in, the market may become more attractive for the consumer.