Video: What's next for the Dow, economy?

By Martin Wolk Executive business editor
updated 10/3/2006 8:36:11 PM ET 2006-10-04T00:36:11

Even though the Dow Jones industrial average closed at a record high Tuesday , there is no chance of confusing the stock market's latest run-up with the go-go days of the late 1990s.

For one thing, the broader Standard & Poor's 500 index, which is more representative of what most investors have in their portfolios, is still more than 12percent below its March 2000 peak, while the tech-heavy Nasdaq composite index is more than 50 percent below its wildly inflated peak of the bubble years.

Plus the 30-stock Dow, the stock market's best-known indicator, has taken more than six years to claw back to its previous peak level of January 2000, gaining an average 13 percent a year over the past four years, compared with 20 to 30 percent annually in the late 1990s.

Still, the Dow's big day caps a strong 11-week run during which broad market indicators have jumped 8 to 10 percent on growing confidence that two significant obstacles have been cleared: the Federal Reserve and rising energy prices.

"The underlying fundamentals have improved," said Hugh Johnson, chairman of Johnson Illington Advisors in Albany, N.Y. "Although the economy has slowed, the inflation rate has moderated and the Federal Reserve has stopped hitting the brake. That is good news, and investors know it. What it really means is that the economy will land softly, and we will not have a recession."

After 17 straight interest rate increases dating to June 2004, central bank policymakers left rates unchanged at their meeting in August and again last month, removing one of the biggest "headwinds" that had been holding the stock market back.

When interest rates were rising, fixed-income securities like bonds and plain-vanilla money market accounts had become more attractive investments, drawing away funds that might otherwise be invested in equities. Plus steadily rising rates were increasing borrowing costs for businesses and consumers, and nobody was quite sure how high they would go. That uncertainty created nervousness in the stock market that has lifted for now.

Meanwhile rapidly dropping oil prices have boosted investor sentiment, easing inflation pressure and putting money back into the pockets of consumers, at least partly offsetting the downdraft from the deteriorating housing market.

"Investors are more comfortable when the Fed is done raising rates for a while and when it costs $30 to fill up the tank instead of $50," said Art Hogan, chief market analyst for Jefferies & Co. in Boston.

In particular, investors are gravitating to big-cap stocks that are well represented in the Dow, including financial companies, which are benefiting from a surge in merger activity boosted by the strong stock market, and manufacturers of consumer staples, which tend to do well even when the economy is growing only slowly.

Almost incredibly, the best-performing stock among the Dow 30 so far this year has been General Motors, which has risen some 70 percent despite Detroit's well-documented problems selling cars and paying for worker health and pension benefits, Hogan pointed out. GM's stock, battered for years, ended 2005 near its lowest level in a quarter-century.

Major Market Indices

While the bulls are running on Wall Street, there are still plenty of threats that could ring the stampede to a sudden halt.  High on the list is the downturn in the housing market, which has helped fuel the economy over the past five years by giving homeowners access to easy cash from the rising value of their home equity.

Plus, the current bull market is now four years old and "things tend to go wrong in the fourth year of a bull market," said Johnson. With the economy slowing sharply from its growth rate earlier this year, the stage is set for a possible misstep.

"Housing could deteriorate more rapidly than we think and drag the rest of the economy with it," he said. "China could go into a tailspin, or terrorists could strike again."

But for now, investors are quietly celebrating. After all, just a few months ago oil was trading over $75 a barrel, Israel was fighting a war in Lebanon and the Federal Reserve was leaning toward pushing interest rates higher.

Now oil is below $60 a barrel, and by early next year, the Fed could be bringing interest rates down again, meaning that yields might have have peaked for conservative investments like money market funds, said Alec Young, equity market strategist at Standard & Poor's.

"There are a lot of positive drivers," said Young. "On a 12-month view, we think equities continue to be the place to be."

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