By John W. Schoen Senior producer
msnbc.com
updated 5/30/2007 6:08:56 PM ET 2007-05-30T22:08:56
ANALYSIS

Money makes the world go around — and these days it’s making the U.S. stock market go up. As long as huge flows of capital continue pouring into stocks, say analysts and market watchers, prices will keep going higher. The question on some investors’ minds: How long can this go on?

Major Market Indices

Apparently defying gravity, the market broke new ground again Wednesday, with the Dow Jones industrial average jumping 111 points to close at 13,633.

The Dow's frequent records have grown almost routine in recent weeks, but even more significant Wednesday was that the broader S&P 500 — the benchmark index used by millions of individual investors and their retirement funds — finally broke through its 7-year-old high-water mark to close at a record 1530.23.

(Among the major indexes only the Nasdaq composite — where the late-1990s Internet bubble was heavily concentrated — has failed to overtake its all-time high. And it is unlikely to do so anytime soon. The Nasdaq index, at 2,592, is at about half its record level of more than 5,000 reached in March 2000.)

But no one is talking about a bubble today. For the moment, the upward trend appears to be all but unstoppable. Since hitting a bear-market low in October 2002 of 776, the Standard & Poor's 500 index has nearly doubled — with only brief retreats along the way. The Dow industrials — also nearly double its 2002 low — have been breaking new ground since October, setting a new record more than once a week on average.

On Wednesday, investors shrugged off a sharp pullback in Chinese stocks, unlike a similar Shanghai selloff in February that took a 500-point bite out of the Dow. This time around, the U.S. market barely skipped a beat.

The focus instead was on a fresh report from the Federal Reserve indicating that while the central bankers are still worried about inflation, they think the odds favor a gradual easing of price pressures. And while the housing slump looks like it may deepen, the Fed doesn't see that weakness dragging the broader economy into a recession, according to the minutes of the latest rate-setting meeting this month. All of which was music to Wall Street's ears.

Still, while the bulls appear to be firmly in charge, there were those offering reminders that bull markets don't last forever.

“You can't have this type of a rally and not expect some sort of a breather,” he said Joseph Moglia, CEO of discount broker TD Ameritrade. “I think we have to get ready for that.”

Trillions for deals
The steady surge in stock prices is being propelled by a flood of money into the global financial markets, fueling a wave of acquisitions that shows no signs of letting up. The binge has been led largely by private pools of capital, so-called private equity funds, that have been buying up public companies and taking them private. As shares of those those companies are removed from the market, there are fewer shares available for institutional and individual investors who are restricted to publicly available stocks. That tends to push remaining stock prices even higher.

The buying binge is the biggest in decades. Some $2.3 trillion in deals worldwide — more than 15,000 of them — have been announced so far this year, according to Thomson Financial. At $857 billion and counting, U.S. private equity buying is more than triple last year's levels.

As the volume of global acquisitions has swollen, so have the price tags on the biggest deals. On Tuesday, the Royal Bank of Scotland offered $96 billion for the Dutch bank ABN Amro. In the past month, wireless carrier Alltel Corp. fetched $25 billion; General Electric agreed to sell its plastics division for nearly $12 billion; news service Reuters went for nearly $18 billion.

(MSNBC.com is a joint venture of Microsoft and GE's NBC Universal unit.)

In some cases, smaller companies are agreeing to buyouts from larger ones to better compete with big global players. In other cases, buyers of public companies believe they’ll perform better off as a private company, freed from some regulatory burdens and Wall Street’s quarter-by-quarter scrutiny of earnings results. At the same time some private companies are now raising more money by coming to market with initial public offerings.

So where is all this money coming from? Much of it is the result of low interest rates, in part thanks to a Federal Reserve policy that is trying to keep the U.S.. economy from sliding into a recession. With energy prices rising and the real estate industry mired in a slump, the pace of U.S. economic growth slowed to just 1.3 percent in the first quarter of 2007.

But while U.S economic growth has been lackluster, the rest of the global economy is firing on all cylinders.

“Typically the U.S. is the locomotive that pulls the rest of the world,” said market strategist Barry Ritholtz of Ritholtz Research. “But in the present environment, we're pretty much the caboose.”

Strong growth abroad has generated cash looking for a place to invest. Some of that cash comes from interest payments on U.S. debt, some from profits on goods exported to the U.S. So overseas investors have been moving that cash back into U.S.

A weak dollar has also attracted cash to U.S. financial markets as overseas investors go bargain hunting. As the dollar goes down, their euros and yen go farther when they buy dollar-denominated assets.

“That is a substantial force, and it’s becomeing an increasingly bigger force," said Hugh Johnson, chairman of Johnson Illington Advisors. “So international capital flows are a big part of this whole process.”

One reason capital is flowing to the U.S. stock market is that it's the largest in the world. Of the $43.6 trillion total value of listed companies worldwide, roughly $17 trillion — or about 40 percent  is made up of U.S. companies, according to the latest figures available from the World Bank. Foreign investors are even getting into the U.S. private equity game. Earlier this month, China's state investment company said it was investing $3 billion in Blackstone Group, the second-largest U.S. private equity firm.

Despite the economic slowdown, the profits of U.S. companies continue to hold up relatively well — thanks again to stable interest rates. First-quarter profit gains for companies in the S&P 500 fell just shy of double digit-growth. But the gains were roughly double what many Wall Street analysts had expected.

Because investors who buy stocks today do so based on expectations of higher future earnings, much of the current buying is based on the widely held view that the U.S. economy will dodge a recession before growth begins to pick up at the beginning of next year. To get in on that hoped-for pick-up in business activity, investors are laying down their bets today.

Even with the recent surge in stocks, the prices investors are paying — relatively to corporate earnings — are not all that high by historical standards.

“The valuations are little a bit high, but this is not 1999-2000,” said Johnson, “Valuations are not at speculative levels.”

In fact, stock investors are paying substantially less for each dollar of earnings than they were at the 2000 market peak. If the stocks that make up the S&P 500 index were selling at the same price-to-earnings ratio as they were in March 2000, the index would now stand at 2,594 — instead of Wednesday's close of 1,527, according to S&P analyst Howard Silverblatt.

But current stock prices are based on expectations that the U.S. economy will pick up next year — and that interest rates will remain low. A rise in rates could quickly throw cold water on the market’s hot streak.

Higher rates would hurt in two ways. First, they would make Treasury bonds look more attractive: Why risk your money on stocks when bonds offer a solid return? That would divert some of the incoming cash stream away from the stock market.

A rise in interest rates would also make it more expensive for companies to carry debt on their books, taking a bite out of profits. And it would raise the cost of borrowing to fund acquisitions.

So far, much of the stock buying has been coming from professional investors. But if the market continues to rise, some analysts expect a pickup in buying from individual investors.

“We think the public will come back,” said Don Hays, president of Hays Advisory. “We're all talking about private equity, but the public has more money than private equity, believe it or not. That money is way on the sidelines."

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