It was a modest up week for equities last week, with the Dow Jones Industrial Average increasing 0.5% to close at 10,841, the S&P 500 Index rising 0.8% to 1,211, and the Nasdaq Composite appreciating 0.3% to 2,065. Following these gains, the Dow and the S&P are now near their high points for 2005. Leading the way again last week was the energy sector, highlighted by ExxonMobil (now the largest capitalization company in the world) climbing over 5%, which represented a significant percentage of the Dow’s gain. Although the markets as a whole are little changed year to date, the market has experienced significant divergences between sectors, indicating (as we have said previously) that selectivity is critical for investors.

The best-performing sector year to date is energy, up over 20%, followed by materials, up 6%. At the other end of the spectrum are technology and telecommunications, down 5% and 6%, respectively. In the fixed income market, last week saw little change in the yield on the 10-year Treasury, which moved from 4.27% to 4.28%. At the shorter end of the curve, however, yields rose and prices fell, continuing the flattening trend that we have been seeing in the yield curve for some time.

It seems clear that the economy is showing resilience in the face of the Federal Reserve’s interest rate hikes and higher oil prices. (Notably, the price of oil once again reached $50 a barrel last week.) Corporations have been accelerating their hiring plans, capital spending remains reasonably robust and merger-and-acquisition activity continues to be strong.

The Fed seems to believe that the economy will continue to expand, and taking note of some inflationary trends, appears positioned to further increase interest rates. Virtually all observers agree that, with continuing interest rate hikes, the federal funds rate will reach at least 3% by the end of the year. Our belief is that the rate will reach 3.5%, and some are forecasting a rate even higher than that. This is partly because core inflation is slowly but surely entering the picture and any deflationary signs are evaporating. We would argue that the probability of a recession is still near 0% and that all the Fed will do by increasing rates will be to slow the economy, similar to what happened in the early 1980s and again in the early 1990s. This scenario will likely cause some difficulty for financial markets, but after some period of a slower economy, we should see renewed gains in financial markets and economic strength.

So far, the equity market has taken oil price increases in stride, largely because when energy prices exceeded $50/barrel last year, bond yields came down. This year, however, we are seeing oil prices moving up at the same time that yields are moving up. If energy prices move up and fixed income rates fall (perhaps telegraphing a weaker economy), we believe the equity market can continue to perform reasonably well. But if both energy prices and bond yields continue to rise, that could be a problem for equities.

Mr. Doll is president and chief investment officer of Merrill Lynch Investment Managers.