The energy sector is at the top of the leader board again. Over the past month energy funds have produced double-digit returns as the price of crude oil surged back near record high levels. Gold is close behind in the race for the strongest sector and it isn’t a coincidence that these two sectors are closely correlated right now.

Last week I wrote about the Federal Reserve. I quoted Bill Poole, president of the Federal Reserve Bank of St. Louis, who said the Fed’s first objective is maintaining price stability–in other words, fighting inflation. In its statement released after its latest meeting, the Federal Open Market Committee said, “inflation expectations remain contained.” Committee members also voted for the 15th straight time to raise interest rates by a quarter percent at that meeting.

Years ago a respected investment analyst advised me to pay more attention to what the Federal Reserve does than to what it says. He made that comment during an earlier period when the Fed was in a year-long pattern of raising interest rates. At that time, after each meeting the FOMC would release a statement saying that inflation wasn’t a concern but it would still go ahead and raise rates. His point was that interest rate hikes and controlling the money supply are the tools the Fed uses to combat inflation. If the Fed was aggressively raising interest rates and cutting back on the money supply, then Fed officials were obviously worried about inflation, even though they said it wasn’t a big concern.

Our situation today is similar. Although the 15 consecutive interest rate hikes have been a modest 25 basis points each, the consistency and duration of the Fed’s action indicate that inflation is a concern. Obviously, rising energy costs are a major component of inflation during the past several years.

In addition to the Fed’s actions, another major indicator of inflation is the price of Gold. Gold has long been used by individual investors, institutions and even governments as a hedge against inflation. When the price of gold is in a sustained advance, it usually means a lot of people are worried about inflation.

Over the past few years, we’ve seen a dramatic rise in the price of gold, coinciding with a similar rise in oil prices. You can see the correlation in the chart below. The black line is the Philadelphia Gold Silver Index (XAU). The gold line is Select Sector SPDR - Energy (XLE). You can easily see that for the four-year period portrayed, the two sectors move together like dance partners.

The blue line on the chart is the S&P 500. I’ve included it because I want you to see how steady and calm it is compared to the other two sectors. The S&P 500 is often used as a benchmark to measure the volatility of another investment. That’s because the volatility of the S&P 500 is about all most investors can emotionally handle. Yet comparing the volatility of the S&P 500 to the gold and energy sectors is like comparing a ride on a carousel to a ride on a wild roller coaster. Notice that over the period of this chart, XAU and XLE have each provided a return about five times greater than the S&P 500. In reality, few investors would ever garner those returns because they would not be able to remain invested during the periods of sharp declines.

The sharp rise over the past four weeks is easy to see for both of these sectors. Here’s is how some representative ETFs performed during that time:

• Merrill Lynch Oil Sv HOLDRS Dep Receipt (OIH) +12.38%
• Comex Gold Trust (IAU) +9.78%
• StreetTRACKS Gold Trust (GLD) +9.62%
• Select Sector SPDR - Energy (XLE) +9.30%
• IShares Dow Jones U.S. Energy Index Fund (IYE) +9.05%

It is likely that these sectors will continue to prosper over the next several months. But they will also continue to be marked by extreme volatility, making them unsuitable for most investors. Those who want to own positions in these sectors should do so only in small quantities, diluted by other positions with more stability.

When the Federal Reserve stops raising interest rates, then we will know that inflation is really under control and these funds will probably tank shortly before that occurs.

Have a great holiday weekend.