(EXTRACT) SOURCE - REUTERS

Wall St Week Ahead: Stocks still have room to extend rally

By Herbert Lash

NEW YORK, June 8 (Reuters) - U.S. stocks could move higher next week after a bond market rout led investors to wonder if the threat of inflation was on the horizon or if the economy was actually stronger than expected, and good for stocks.

Major stock market gauges recovered on Friday after a bond sell-off pushed the benchmark 10-year U.S. Treasury note's yield up to 5.25 percent -- matching the fed funds rate target at one point -- from levels below 5 percent a week ago. That jump in government bond yields rattled investors who, skittish about a bull market that has lasted longer than most, worry that rising capital costs will cut corporate profits.

Around midday on Friday, stocks began rallying as the 10-year note's yield retreated to around 5.11 percent.

Friday's recovery after a three-day slide is a good indication of where the market is headed as investors realized they overreacted to a spike in market interest rates, said David Joy, market strategist at RiverSource Investments.

"Interest rates are where they should be, and we haven't had any inflation. This a little adjustment to a new level of rates, a level that the stock market doesn't have a problem with," Joy said.

The blue-chip Dow Jones industrial average climbed 157.66 points, or 1.19 percent, to end Friday's session at 13,424.39. The broad Standard & Poor's 500 index gained 16.95 points, or 1.14 percent, to finish at 1,507.67. The Nasdaq Composite Index advanced 32.16 points, or 1.27 percent, to close at 2,573.54.

Falling oil prices on Friday also helped the major U.S. stock indexes rebound. U.S. crude oil for July slid $2.17 to settle at $64.76 a barrel on the New York Mercantile Exchange. For the week, NYMEX July crude fell 32 cents.

For the week, though, the effects of the pullback were visible, with the Dow average ending down 1.78 percent, the S&P 500 falling 1.87 percent and the Nasdaq losing 1.54 percent.

For the year so far, however, the Dow is still up 7.71 percent, while the S&P 500 is up 6.30 percent and the Nasdaq is up 6.55 percent.

With memories of the dot-com bust still fresh, many investors are cautious and trying to identify an inflection point, Joy said. But stronger growth, absent inflationary pressures, is good for stocks, he said.

"The bond market has realized rates should be a little higher, given how strong the economy is," he said.

Investors will look for any change in language about interest rates when the Federal Reserve releases its Beige Book summary of regional economic conditions on Wednesday. Joy said he didn't expect to see the Fed change its interest-rate stance. Since last June, the Fed has held its fed funds rate for overnight bank loans steady at 5.25 percent.

CPI ON THE BRAIN

The headline to watch for next week is inflation data that comes out on Friday, and possible inflationary signs in an industrial output and capacity utilization report later that day, Joy said.

Investors will be a little bit wary of Friday's inflation data, leading to a drop in trading the day before, he said. But inflationary pressures are unlikely to appear for another six months or more, he said.

A Labor Department report is expected to show that the overall U.S. Consumer Price Index rose 0.6 percent in May from 0.4 percent a month earlier. Stripping out food and energy, the core CPI likely rose 0.2 percent in May, the same as in April, according to economists polled by Reuters.

U.S. industrial production probably increased in May, up 0.2 percent after April's rise of 0.7 percent, according to the Reuters poll. Capacity utilization at factories likely stayed the same at 81.6 percent in May.

Friday's CPI data will be preceded on Thursday by a look at prices at the wholesale level. The forecast for the overall U.S. Producer Price Index calls for a gain of 0.6 percent in May, following an increase of 0.4 percent in April, according to the Reuters poll. Core PPI, excluding volatile food and energy prices, probably rose 0.2 percent in May, in comparison with no change in April.

Among other data expected on Friday will be a preliminary reading on U.S. consumer sentiment in June from the Reuters/University of Michigan Surveys of Consumers. The June consumer sentiment index is forecast at 88.0, down from 88.3 in May.

Manufacturing activity in New York state, as seen by the New York Fed's "Empire State" general business conditions index, likely rose to 10.8 in June from 8.03 in May.

WHAT THE BANKERS SEE

Investors will get a taste of second-quarter earnings next week when chip maker Texas Instruments provides a mid-quarter financial update on Monday, and three of Wall Street's largest investment banks release fiscal quarter results.

Lehman Brothers reports on Tuesday, while Bear Stearns and Goldman Sachs report on Thursday. All three investment banks will release their quarterly scorecards before the opening bell on those respective days.

"People will look to the brokerage comments about the markets in general and their outlook for their own companies," said Mark Bronzo, managing director at Gartmore Separate Accounts in Irvington, New York.

(Wall St Week Ahead runs weekly. Questions or comments on this column can be e-mailed to: herbert.lash(at)reuters.com)