The stock market hit multiyear highs recently, but was down last week as the combination of the trade deficit, mixed economic news, high oil prices, and a resumed decline in the American dollar hurt both stocks and bonds.

For the week, the Dow Jones Industrial Average fell 1.5% to close at 10,774, the S&P 500 Index dropped 1.8% to 1,200, and the Nasdaq lost 1.4% to end the week at 2,042. In the bond market, prices fell as the yield on the 10-year Treasury climbed above the 4.50% mark for the first time since last summer, ending the week at 4.54%.

Until last week, stocks have largely ignored the recent trend of increasing interest rates (the yield on the 10-year Treasury is up more than 50 basis points from its low in February).

While some sectors, such as financial stocks, have underperformed lately, the overall market has done reasonably well in this rising-rate environment. Such an environment, however, is a negative for equity valuations and will eventually hurt corporate profits, especially when coupled with rising energy prices. Regarding profits, some analysts have recently been focusing on the fact that the Consumer Price Index has been increasing at less than the rate of the Producer Price Index for the first time in 13 years. Producer prices moving up more than consumer prices underscores the lack of pricing power and highlights the fact that companies are facing margin pressures. As a result, we believe that investors would be well advised to focus their attention on companies that can maintain their margins (perhaps through pricing power and strong earnings) as well as on companies exhibiting rising dividend payouts. In our opinion, equity valuations generally remain at best neutral on an absolute basis but are still attractive compared to bonds. If interest rates continue to rise, however, valuations will start looking less and less compelling.

The economy has continued to do reasonably well, and inflationary pressures have increased to the point where core inflation is rising. Our belief is that current inflationary risks are cyclical in nature, and that if the economy were to experience a period of subpar growth, these pricing pressures would fade away, especially since there are still some global deflationary forces at work.

For the longer term, our view is that we are in a period of low and relatively flat inflation, although we will likely see some inflation scares along the way, and could be in one right now.

With the economy doing reasonably well, we think the Federal Reserve will continue to raise interest rates. Rising rates, combined with increasing energy prices, will likely result in a slowing of economic growth in the second half of this year, if not in the second quarter.

Hopefully, such a period of slower growth will end late this year or early next year. In the meantime, however, there might be some shorter-term pain for investors in this muddling-through environment we have been describing since the beginning of this year.