What a Week: Still Strong

Stocks find a way to rise despite Katrina and creeping inflation.
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Neither epic flood nor gathering economic storm could distract the stock market from its single-minded focus on energy prices this week. The result was another round of surprisingly robust gains for the ever-resilient U.S. investor.

Despite mounting evidence that the

Federal Reserve

isn't done raising rates, stocks bolted higher on both Tuesday and Wednesday before riding another oil-related upswing in the week's last day. Over the four sessions since Labor Day, the

Dow Jones Industrial Average

gained 231.19 points, or 2.21%, to 10,678.56. The

S&P 500

rose 23.46 points, or 1.92%, to 1241.48, while the

Nasdaq Composite

added 34.44 points, or 1.61%, to 2175.51.

"We built on a relief rally," said Jay Suskind, head of institutional equity trading with Ryan Beck & Co. "From an economic standpoint, things picked up after the price rise in oil dropped. It showed the resilience of the economy."

On the Gulf Coast, halting relief was felt as retailers tried to rebuild and several storm-damaged refineries got back on line, helping to ease crude and gasoline prices. Crude, which went above $70 in Katrina's immediate aftermath, fell 5.2% this week to close pit trading Friday at $64.08 a barrel. Gasoline prices fell to $1.96 a gallon, a 10.1% drop from last week's closing price of $2.18.

Even as oil prices fell, oil stocks rose, accounting for virtually all of the broader market's gain this week. The Amex oil index rose 3.2% over the four sessions and is up 12.4% since Katrina came ashore. The rally has been led by

Valero

(VLO) - Get Report

, which has added 6% for the week and over 28.7% since the hurricane, leaving it at an all-time high.

Heating oil, which hit its own zenith last week (Sept. 1) at $2.19 a gallon, fell roughly 13% this week and traded at $1.90 a gallon. Meanwhile, natural gas prices held firmly near the all-time high of $11.76 per thousand cubic feet reached last week, trading at $11.20.

The violent movement in energy prices leaves the

Fed

with a particularly tough call when it meets a week from Tuesday, but the pendulum seems to be swinging toward the hawks. On Wednesday, Chicago Fed President Michael Moskow expressed concern about core inflation running "at the upper end of the range that I feel is consistent with price stability."

"If we indeed start to see a string of higher inflation numbers, people may begin to expect permanently higher inflation," said Moskow. "If this occurred, the Fed would need to respond accordingly in order to restore price stability."

That spelled it out for traders. Though fed fund futures odds of the FOMC raising rates at its next meeting went as low as 50% last week, there is now an 80% chance the committee will raise by 25 basis points.

"Because the economy seems so resilient in the face of these energy price increases, it appeared margins might have been squeezed in earnings. The price increases, however, seem to be turned over to the consumers," said Suskind. "That's obviously good for corporate margins but unfortunate for inflation."

Meanwhile, as the market stopped discounting fewer rate hikes by the Fed this year, bond yields ticked higher for the week. After last week's rally, which sent 10-year Treasury yields to 4.03%, the benchmark note finished Friday with a yield of 4.12%.

Some strategists argue that it is too soon to be wagering on the Fed until Katrina's total impact on the economy can be better understood.

"Without having full information and gathering all the facts, it's a big jump for the market to be assuming anything," said Barry Hyman, equity market strategist with Ehrenkrantz King Nussbaum. "I'd rather see more data before making a judgment about how hard the economy will be hit. You don't know how the consumer will be affected psychologically, especially regarding energy prices and consumer spending."

The uncertainty was reflected in the confused tone of the week's economic commentary. In a televised interview Tuesday, Robert McTeer, former Federal Reserve Bank of Dallas president, said he saw no need for the FOMC to raise rates when it next meets. A day later, Moskow made his hawkish remarks.

On Thursday night, San Francisco Fed President Janet Yellen said the storm remains the economy's biggest threat. "The size of these impacts depends in part on how quickly the vast energy infrastructure in the region can be brought back to operating condition," Yellen said. A day later, Treasury Secretary John Snow was on television saying the storm's impact would be "temporary."

On Wall Street, Morgan Stanley on Wednesday cut its forecast for 2005 GDP growth to 3.5% from 3.8% and now expects 2006 U.S. growth at 3.3%. The investment bank also lowered its global GDP forecast for 2006 to a growth rate of 3.7% from 4.1%, as it expects 40% rise in crude oil prices for 2006.

The divergence of opinion shows how difficult it is for anyone to make a meaningful judgment at this early stage. Whether the task will get easier by Sept. 20 is an open question.

"We don't know what the Fed will do, and we don't know how high crude prices will go. We also don't know how much money or time we need to dedicate to the Gulf Coast," says Hyman. "It will end up being a plus to the economy, but to minimize the hit within such a short time is a little bit of a stretch. Even though we want finality, things need to be judged on a quarterly basis, not a weekly basis."

To view Gregg Greenberg's video take on today's market, click here

.

In keeping with TSC's editorial policy, Worden doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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