Over the years, I’ve generally recommended all long-term income investors keep some energy in their portfolios as a hedge against a revival of inflation. Energy prices and energy stocks have historically rallied whenever inflation and economic growth are picking up steam. By owning high-yielding energy plays, income investors can get a yield while protecting their portfolios from an overheated economy.

All good things, of course, come to an end. And earlier this year, the relationship decisively broke down. Oil prices remained high, but interest rates nonetheless reacted to new Federal Reserve Chairman Ben Bernanke’s upward push by heading skyward.

The benchmark 10-year Treasury note yield smashed decisively through the 5 percent mark it had failed to crack in 2003, 2004 and 2005, and then proceeded to surge as high as 5.3 percent. More than one technician I respect assured me the next stop was 5.5 or even 6 percent, and the action in the charts certainly seemed to back them up.

The market as a whole was convinced that inflation was at last catching up to interest rates, and that the Federal Reserve would continue to clamp down hard on growth in response. That was at least the clear message in the Federal Funds futures rates, which forecasted more rate hikes ahead.

Then, just as quickly, market psychology shifted 180 degrees. First, the Fed abruptly ended its streak of monthly interest rate increases, pronouncing the risk of an economic slowdown was now at least equal to that of faster inflation. And despite core inflation (less food and energy) that remains stubbornly high, the market and central bank instead began to focus on the signs of weakness in the economy, particularly in the housing market.

After peaking in the 5.3 percent area, the 10-year yield began to respond by heading lower. In late July, the yield again fell below 5 percent, and, after a brief spike in mid-August, began to fall at an accelerating rate. Today, the yield sits at just 4.6 percent, its lowest level since mid-March. That marks almost a full retracement of the spring rate spike.

Meanwhile, energy prices have begun to weaken in earnest. Natural gas has cracked the $5 per million Btu threshold, a level that just a few months ago virtually no one believed it would revisit. Oil, meanwhile, is sinking toward $60 per barrel and is likely to move sharply lower on any real break below that mark.

In sum, energy prices and interest rates are again moving counter to each other, as investor worries about the economy grow. Weaker growth is now considered deadly for energy prices as it’s presumed to slacken demand for oil and gas, inventories of which are high due in large part to mild weather. Weaker growth, in contrast, is considered positive for interest rates, as demand for money slackens, inflation backs off and the Federal Reserve becomes more accommodating.

UNDER PERFORMING

Falling interest rates have been a big positive for bonds and preferred stocks, which are a hybrid between debt and equity. Those recommended in Utility Forecaster and Personal Finance have gotten a lift in recent weeks. In fact, because our selections are from companies with improving credit standing, most stand above where they were last spring before the rate spike.

On the other hand, prices of other traditional income investments haven’t fared as well. Utility stocks, for example, are still well off the lows they set earlier this year, but the Dow Jones Utility Average has also backed well off its recent high.

Communications utilities--particularly those offering high yields--have continued to trend higher. But water companies have tumbled, pipeline limited partnerships have languished and power and gas utes have backed down. US real estate investment trusts (REITs) have also come off their high points, even the apartment REITs that continue to enjoy a robust market for rents. Bank stocks are normally a beneficiary of falling interest rates, but they too have retracted except for the very strongest of the regional banks like REGIONS BANK (NYSE: RF).

Prosperity in Canadian REITs, power trusts, pipelines and business trusts has little to do with the level of energy prices and benefits richly when interest rates come down. Nonetheless, this group has been weak as well, despite strength in the Canadian dollar.

In other words, the income investing universe has been underperforming in recent weeks despite a dramatic reversal and rapid decline in interest rates. Some of the blame has to be borne by the sky-high valuations stocks have received for perceived safety and reliable dividends. But this is also the kind of action we’ve seen when the market is worried about the economy and there’s a flight to quality.

Certainly this is reflected in the way the commodity market has been crushed during the past several months. Aside from oil and gas, coal has been battered. Lumber futures prices--which respond to construction forecasts--are down 27 percent from their highs. So are most agricultural commodities, including coffee, down nearly 30 percent from its high.

Under normal circumstances, these price signals for the economy’s most basic building blocks would be signaling one thing: recession.

In this case, however, that’s far from clear.

For one thing, measures of the economy’s current health are still relatively pink. Unemployment is low and most sectors appear to be chugging along, neither tearing up the track nor falling off the rails.

Rather, I suspect a lot of the action in commodity markets now is simply the unwinding of a buying frenzy on the part of large investors and hedge funds over the past year or two. The crisis at Greenwich, Connecticut-based hedge fund Amaranth this week is certainly more evidence of market behavior that would otherwise be quite silly were it not so devastating for investors.

Amaranth apparently let a Calgary-based energy trader keep doubling down its bullish bets on natural gas prices, even as they sank by more than two-thirds this year. No doubt there have been a lot of longs to clear off the books at any price. Does anyone remember Nicky Leeson?

Sooner or later, federal authorities will no doubt clamp down on hedge funds, probably with the effect of killing off the good as well as the bad. Until that happens, however, this kind of volatility is going to take place, particularly whenever a market heads radically in one direction or another. This kind of short-term money is going to continue to accelerate all selloffs and rallies, and we may as well get used to it.

The good news is if you buy a collection of high quality stocks from a range of industries--i.e., companies with growing, healthy businesses--this type of volatility is little more than an abstraction. The bad news is that even the best-constructed portfolio isn’t proof in the near-term against this kind of thing.

And the current market action proves it.

WHAT TO DO

My view is we still have one more downleg for energy prices in the near term. But the long-term bull market in energy will remain in place until there’s a fundamental shift in the world balance of power in energy from producers to consumers. That won’t happen until there’s more conservation, a move to alternative energy, a real discovery of conventional reserves and very likely a recession.

At this point, I don’t believe the world’s central banks will risk a recession. That’s the clear message from the Federal Reserve’s continued holding action on interest rates despite a stubbornly high core rate of inflation. Americans have stopped buying gas guzzlers, but they’re still driving the ones they already own as much as before. And the recent drop in gasoline prices will only reinforce those consumption habits.

As for alternatives, we’re using all the ethanol we can get our hands on as a fuel additive, not an alternative to oil. And ethanol is simply not economic unless oil prices are at high levels. The next nuclear plant is a decade away and wind is only capable of generating in niche areas. The only new discoveries of energy are non-conventional, such as CHEVRON’S (NYSE: CVX) deepwater Gulf of Mexico find and Canada’s oil sands. Those won’t be economic unless oil and gas prices stay high.

In short, we don’t have any of the conditions in place that ended the 1970s bull market in energy. That means this is a correction--a vicious one, perhaps, but one that will ultimately end in a buying opportunity.

As for interest rates, as long as the Federal Reserve is forbearing on inflation, the 10-year Treasury yield is likely to head lower still. And it’s possible inflation will cool off as well, pushing down rates further still. Finally, continued worries about the economy will also be bullish for the 10-year due to the flight to quality.

Falling interest rates, however, can’t be counted on to lift all boats in the rate-sensitive camp. Wall Street’s favorite places to look for yield, for example, are no longer cheap. You’ve got to get a little more creative in your selections.

The rules of the game are still the same for the long-term investor.

You look for securities issued by companies that are growing their businesses, and you try to buy them when the Street is looking the other way. You won’t make money every day or even every week. But if you’re patient, you’ll reap steady total returns and growing dividends for years to come, leaving well enough alone when traders are getting all chewed up inside about the market’s latest gyrations.

My suggestion this week is to look at preferred stocks. These will require a little more work to buy than the typical NYSE common stock, though most are NYSE-listed themselves. Some can be redeemed at a designated call price on a certain call date. But if you take the time to find good preferred stocks of growing companies--the same criteria for which you’d choose a common stock--you’ll realize yields that beat the average equity by a mile, with a lot less volatility.

(NYSE: AES C), yielding over 7 percent paid quarterly and convertible into one of the world’s fastest-growing power companies.

Roger Conrad is Editor of UTILITY & INCOME