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Stock market bull is feeding on corporate profits

Things are looking up. Traders work on the floor of the New York Stock Exchange on March 28, 2013 when the S&P 500 finished at an all time high.
Things are looking up. Traders work on the floor of the New York Stock Exchange on March 28, 2013 when the S&P 500 finished at an all time high.Spencer Platt / Getty Images

Four years after pushing investors into one of the deepest financial holes in a century, the U.S. stock market is now powering ahead in one of the strongest bull markets in a half century.

So it’s no surprise many investors are wondering how much longer it can last.

Fueled by growing signs that the U.S. economy is finally repairing lingering damage from the Great Recession, stock prices have been making new highs for weeks.

On Thursday, the S&P 500 index closed at its highest level in history, after rising for 11 of the past 13 weeks. The Dow Jones industrial average, which tracks just 30 stocks, broke into record territory March 5 and has been setting new highs since. (Neither index, however, has reached a new high after adjusting for inflation.)

In the last 10 months, stocks have risen nearly 25 percent, as measured by the S&P 500 index. Since August, 2010, the broader Wilshire 5000 index has powered ahead by 50 percent – a rally that’s created more than $6 trillion in wealth for U.S. households, corporations, pension funds and other institutional investors.

To some investors still shell-shocked from the 2008 financial collapse, it’s beginning to feel like October 2007 – just before the bottom fell out. Or 2000, when the dot-com bubble popped.

Take a deep breath. Those worries are simply misplaced, according to none other than former Federal Reserve Chairman Alan Greenspan, who coined the now-famous phrase for the telltale sign that a stock market party is getting out of hand.

"'Irrational exuberance' is the last term I'd use to characterize what’s going on at the moment,” the retired central banker recently told CNBC. “It's got a ways to go as far as I can see.”

To be sure, bull markets inevitably include sharp pullbacks, as some investors take profits or others have second thoughts about the rally's staying power.

But for now, the millions of investors who are pouring billions of dollars into the stock market every week seem to agree with The Maestro. Here’s why:

So what got this party started?
Much like most market recoveries, the initial stage represented a snap back from one of the worst financial collapses since the Great Depression. Markets often act like a rubber band: If they get pulled too far in one direction, they tend to want to snap back to more “normal” levels. The 2008 crash left stocks at deeply-depressed, bargain prices. But until the recovery was solidly in place, buyers had to be willing to bear the risk that the down cycle hadn't run its course.

In the last six months, the stock market rally has entered a new phase, driven largely by good news about the economy. The housing market has now bounced back sharply from the deepest recession in generations. Rising home prices have helped rebuild much of the multi-trillion dollar loss in household wealth that was obliterated by the collapse of 2008.

To be sure, it’s not all good news. The economy remains sluggish. Europe is struggling through a recession. The unemployment rate – through steadily declining – remains painfully high. Not all companies are taking part in the market rally.

Sorry: What makes stock prices go up and down again?
In the short term, supply and demand – just like a pair of Red Sox tickets on Stubhub. When there are more buyers than sellers, the price goes up. And vice versa.

Profits push stocks higher
SOURCE: Standard and PoorsNBCNews

Over the longer run, demand for a given company’s stock is driven largely by its prospects for becoming more profitable. As any Red Sox season ticket holder knows, there’s a lot more demand for unused Fenway seats when the team is on a roll than when they’re losing.

As profits go up, so do stock prices. But to make money, you’ve got to own the stock before the company announces higher earnings.

That’s why investors are buying now – based on the belief that the recent improvement in the economy will continue this year and next.

“I don't think it's all that surprising that the stock market would rise, given that there has been increased optimism about the economy,” the current Fed chairman, Ben Bernanke, told reporters earlier this month. “Profit increases have been substantial. And the relationship between stock prices and earnings is not particularly unusual at this point.”

But didn'tBernanke create this bubble by pumping trillions of dollars cash into the system?
The Fed’s unprecedented, ongoing easy-money policy has certainty had a lot to do with the surge in stock prices.

Ultra-low interest rates have helped two ways. Cheap credit helps boost economic growth; the housing recovery would have taken a lot longer without record low mortgage rates. Ultra-low rates on safer investments like bonds also force investors looking for higher returns by turning to riskier investments like stocks.

It’s a premature to call this rally a bubble. The late-90s Internet craze “went bubble” when investors began paying Gold Rush prices for companies with no profits whatsoever. They were betting – based on wildly optimistic forecasts about future growth – that profits would eventually kick in. But in the end, it turned out that launching the fourth-largest online shopping site targeting left-handed golfers wasn’t a winning business model after all.

Ironically, some of the trends underlying those 1990s forecasts - of a millennial boom in entirely new online products and services – are now helping boost corporate profits today. In many cases the predictions were right. They were just 20 years too early.

OK.Butif the economy is still weak, where are all these profits coming from?
One big source is workers’ wages – which have been falling, after adjusting for inflation. As business improves, more of that cash is heading straight to the corporate bottom line.

It’s not hard to see why. With unemployment still at 7.7 percent, few workers have leverage to demand a raise. Many companies have also been able to meet increased demand by asking their existing workers to put in more hours and check their email on weekends. Globalization continues to offer opportunities to outsource work to low-wage, overseas markets.

As the job market improves, and companies continue adding more full-time workers, that added profit may begin to slow. Higher health care costs could also take a bite. But for now, much of the revenue from new orders is flowing to the bottom line with little increase in labor costs.

Falling wages are only one of the tailwinds pushing profits ahead. Just as ultra-low interest rates have helped homeowners cut their monthly mortgage payments, companies have gotten a big break on borrowing costs. Those savings have helped boost the bottom lines of the companies in the S&P 500 index by some 4.5 percent, according to financial analyst Stephen Moore.

Moore figures lower corporate taxes – which have fallen from about 30 percent of overall profits in the 1980s to around 20 percent today – have added another 1 percent to profits.

We’d add to the list the ongoing savings from lower natural gas and electricity costs thanks to a boom in U.S. energy production.

So how long can all this last?
The only honest answer: No one knows. Including your investment adviser.

The recent recovery from a period of deep, financial malaise, though, is reminiscent of the 1980s emergence from the Great Inflation that destroyed thousands of businesses, trillions of dollars in financial assets and shredded consumer and investor confidence.

Then, for a variety of reasons, the economic storm subsided. In what seemed like a matter of months, it was Morning in America. The resulting stock market rally, which began in August 1982, was one of the longest on record.

To be sure, the over-caffeinated bull briefly passed out when a heart-stopping crash lopped 23 percent off stock prices in a single session on October 19, 1987. Four months later, though, the bull was back on his feet for another 12-year stampede that lifted stocks nearly seven-fold before the tech bubble burst in March 2000.

This bull faces formidable hurdles in the months and years ahead. The ongoing debt crisis in Europe and, worse, the bumbling response of its leaders, could easily spoil the party. So could the inevitable day, probably not until next year, when the Fed starts raising interest rates back to more normal levels. The Washington budget battle over reforming unsustainable federal spending (a problem with no shortage of viable solutions) could also knock the bull off its feet.

And if the gains in corporate profits stall out, investors could quickly lose their appetite for stocks. Until that happens, though, this rally looks like the real thing.