By John W. Schoen Senior producer
updated 10/4/2007 7:16:53 PM ET 2007-10-04T23:16:53

With the housing market in a tailspin, some economists ratcheting up recession forecasts, and major banks reporting big losses, the stock market is on a roll, rising to record highs. How can that be?

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The simple answer: Investors care less about what’s happening today than about what they expect to happen tomorrow. And, as bad as today’s headlines look, they’re not as bad as Wall Street’s worst fears at the height of the turmoil that rocked the global financial markets in August.

For weeks, Wall Street has been watching the collapse of the housing market, along with the meltdown of the mortgage market, and waiting to see just how badly banks and other financial institutions had been weakened. As more and more loans went bad, a number of smaller lenders, especially those that specialized in subprime loans, closed their doors or got snapped up by larger firms. What wasn’t clear was just how badly the biggest lenders were hit by the credit meltdown.

On Monday, a big piece of uncertainty was resolved when Citigroup warned that third-quarter earnings will probably drop by 60 percent, as the nation's biggest financial institution takes more than $3 billion in writedowns for securities backed by bad mortgages and troubled loans for corporate buyouts. Swiss bank UBS also said Monday it will post a loss of up to $690 million in the third quarter, partly due to losses linked to U.S. subprime mortgages.

Video: The Profit Picture While those numbers are big, investors seem to think they’re manageable, said Sam Stovall, chief investment strategist at Standard & Poor's.

“They were assuming the worst,” he said. “What’s happening is that they are now being able to quantify it. And they’re saying, 'Gee, these are big companies, and it’s something they would rather not do, but they can handle it.'”

Some market watchers also believe that lenders now reporting losses or big writedowns are positioning themselves for possible bad loans to come. The sharp increase in mortgage defaults, and the resulting damage to their loan portfolios and mortgage-backed bond holdings, provides banks with a strong cover to get as much bad news out of the way as possible. According to that view, while more loan problems may lie ahead, they won’t be as bad as those now being reported for three-month period just ended.

But not everyone is convinced the financial storm that all but shut down global credit markets in early August — and lopped nearly 10 percent off stock prices this summer — has passed.

“There will be more write-offs of this nature; this is a systemic crisis,” said Richard Bove, a veteran banking analysts now with Punk, Ziegel. “People simply don't believe that there is a crisis of this nature out there. They believe that basically the Federal Reserve can solve any problem whatsoever."

Big interest rate cuts by the Fed — a "Zorro-like" move slashing two key lending rates by a half point last month — have helped ease investor fears, said Stovall.

"That pretty much told investors, ‘Hey the Fed is going to do what it needs to do to avoid recession,'” he said.

Even before its bold rate cut last month, the central bank had been pumping money into the financial system in early August to counteract a sharp tightening of credit. That helped provide investors with more money to buy stocks. And with interest rates falling on Treasury securities, some investors seeking a higher return shifted money into the stock market.

The confidence in the Fed’s willingness to cut rates could prove to be the bull market’s Achilles heel. If the Fed fails to cut rates again Oct. 31 after its next regular meeting of policymakers, some investors may head for the exits.

But the hope is that the Fed's aggressive rate cuts indicate that the central bank is committed to preventing the collapse of the housing market from widening into a full-blown U.S. recession.

“We don't think that the weakness in housing has spilled over to the rest of the marketplace,” said David Joy, chief market strategist with RiverSource Investments in Minneapolis. “And as a result, once you get beyond that, businesses are strong, manufacturing is strong, government spending is strong.”

Even if the U.S. economy weakens, many investors are betting that any slowdown here will be offset by continued strong growth overseas, especially in emerging economies like China and India.

One reason for the optimism about the U.S. economy, ironically, is the weakness in the dollar, which hit a record low against the euro on Monday. That has hurt Americans who travel overseas, and it could raise prices of imported goods sold in the U.S. But it has also given a big boost to the profits of U.S. companies that export products or have substantial operations overseas.

A weak dollar helps make U.S. products look cheap in foreign markets. And profits made in stronger foreign currencies look bigger when brought back home and converted into dollars. Roughly half the companies in the S&P 500 index earn a significant portion of their profits from overseas operations.

Over the longer term, those profits are what matter to investors who buy stocks. And despite recession fears, the analysts who forecast profits see good times ahead for U.S. companies. While some bank profits are expected to continue to suffer from problems with bad loans, other industry sectors are expected to post healthy profit gains when those reports begin rolling in over the next few weeks. For the 500 companies included in the S&P 500 index, overall profits are expected to end 2007 7 percent higher; next year, profits are expected to rise 13 percent, according to a survey by Thomson Financial.

Based on historical averages, stock prices are actually still a bit underpriced when compared with the latest year's earnings. The S&P 500 currently stands about 17.1 times operating profits per share of companies included in the index, based on earnings reported for the past 12 months. That’s 12 percent lower than the historical average of 19.4 times operating profits, according to Stovall.


(The Associated Press contributed to this story.)


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