However, should the economy show continued signs of excessive weakness, the Fed will act again. The structure of the fixed income yield curve supports the idea that an economic recovery is on the way. We believe that 2001 s return to a more typical yield curve, in which investors get higher rates in return for the risk of holding bonds for longer periods, signals a shift to economic recovery rather than a return to inflation. Inflation is likely to remain moderate because energy prices appear to have peaked, many companies can t raise prices, and slow growth has created slack in the economy. Also, the U.S. dollar exchange rates and U.S. productivity remain at high levels.
Stock prices tend to anticipate an economic recovery.
However, it s not unusual for the market to re-test its lows. By that time, however, the market is typically beyond the start of its rally. We believe that stock selection will be more important than sector selection. We recommend that investors use small-capitalization and international stocks within the context of a carefully considered asset allocation. To the extent that these stocks do not move in tandem with an investor s other holdings, they may reduce the volatility of portfolio returns by offsetting downswings or less outstanding performance in other asset classes.