In a crummy economy, why are stocks soaring?

[September 17, 2012]  WASHINGTON (AP) -- Economic growth is pitiful. Unemployment has topped 8 percent for an exhausting 43 months. The nation is careering toward a so-called fiscal cliff, and maybe a recession.

So why is the Dow Jones industrial average, that trusty gauge of corporate America's strength, just 4 percent shy of an all-time record? And why are the smaller public companies measured by the Russell 2000 index almost there already?

Start with two words: Ben Bernanke.

Bernanke, the Federal Reserve chairman, last week announced unprecedented measures aimed at lifting the sagging economy -- and boosting the prices of assets like stocks and houses. The market rallied all summer in anticipation of such a move.

The Fed made an open-ended promise to purchase $40 billion a month in mortgage bonds and said it will keep interest rates low through 2015, even if the economy starts to improve.

The announcement set off a two-day rally that drove the Dow up 260 points, leaving it less than 600 points shy of its record high -- 14,164, reached on Oct. 9, 2007, two months before the Great Recession began.

The Standard & Poor's 500 index, a broader measure of the market's strength, would need to gain less than 7 percent to surpass its own record, reached on the same day.

There's ample reason to think Bernanke's prescription will work, at least for stocks. The idea is to pump money into the economy to push interest rates even lower, which encourages spending, and drive up stocks, which makes people feel richer.

The hope is that also will drive people out of investments based on interest rates, such as CDs and bond mutual funds, and into stocks. If stock prices rise, investors will be richer and more likely to spend. It's called the "wealth effect."

The measures are the Fed's third round of so-called quantitative easing. It's the fourth round if you count a similar, ongoing plan known as Operation Twist under which the Fed drives down long-term interest rates.

The earlier actions were rocket boosters for stocks:

• The first round was announced in its full $1.2 trillion form in March 2009, at the depths of the recession. From there, the Dow gained 45 percent over the following year. The S&P 500 rose even more.

• Bernanke hinted at a second round in August 2010. From then until it ended June 30, 2011, the Dow added 24 percent.

• Between the launch of Operation Twist last September and Wednesday, the day before the Fed's announcement, all three indexes rose more than 20 percent.

The Fed's actions work in part because they help make U.S. stocks one of the least ugly investments out there. Big American companies are a stable bet compared with Europe and many emerging markets.

People might prefer the safety of Treasurys, but the Fed is shooing them away, pushing yields so low that, adjusting for inflation, investors end up paying the government to hold on to their money.

There's no denying the Fed measures draw investors into stocks, says Tyler Vernon, chief investment officer of Biltmore Capital, an investment adviser in Princeton, N.J.

But without some improvement in the economy itself, he says, the effects will be fleeting.

"We've had this recovery in the stock market but not really in the economy," Vernon says. Stocks will likely fall within months, he says, "when the same stories are coming out about the economy, when we start hearing the same old song of people dropping out of the workforce and unemployment staying high."

There are other factors that help explain stocks' recent gains. Investors expect corporate profits to rise strongly in the fourth quarter, after a trough in the quarter that ends later this month, says Sam Stovall, chief equity strategist with S&P Capital IQ, a research firm.

And by one key measure, stocks are relatively cheap. Analysts often assess a stock's value by looking at the ratio of its price to the company's earnings per share. Right now, prices are about 14.5 times earnings over the past year, Stovall says. The median over the past quarter-century is 17.9.

Hopes for an economic rebound are rising now that Europe has a better handle on its debt crisis. Investors were relieved this month by news that the European Central Bank will buy bonds from debt-strapped countries and Germany will participate in a crucial bailout fund.

Despite the wave of optimism, though, a record for the stock market isn't a sure thing. If the next few monthly jobs reports are as weak as the last few, the unemployment rate will likely rise -- a discouraging sign that nearly everyone notices.

And corporate profits are expected to be down in the current quarter compared with last year, in many cases because of weak demand in recession-plagued Europe.

Europe's stability is far from guaranteed. In the three years the debt crisis there has loomed over markets, several apparent solutions have turned out to be false starts.

Economists' greatest fear is the so-called fiscal cliff, a set of automatic tax increases and government spending cuts that take effect at the end of this year unless Congress acts.

President Barack Obama and many Democrats want to allow certain tax breaks to expire only for wealthier Americans. Republicans want to keep them for everybody.

Without a deal, taxes will rise, reducing people's ability to spend and invest. A budget standoff could lead to massive cuts in spending on defense and social programs.

If people are paying higher taxes while the government spends less, that could sink the recovery, says Ron Florance, managing director of investment strategy for Wells Fargo Private Bank in Scottsdale, Ariz.

"If Congress doesn't do something about the fiscal cliff, the math adds up to a recession," he says.

Meanwhile, the Fed-fueled rally could easily push indexes past all records -- a remarkable feat considering that unemployment is above 8 percent. During the Dow's recent cyclical peaks -- August 1987, January 2000 and October 2007 -- unemployment was between 4 and 6 percent.

Jeff Sica, president and chief investment officer of SICA Wealth Management in Morristown, N.J., says investors shouldn't put too much stock in whatever the Fed is cooking up.

The Fed has created a "false sense of security, that as bad as things get, the Fed is going to step in and make it better," Sica says. "The Federal Reserve would never expand their mandate had they not felt that the economy was very, very bad."

[Associated Press; By DANIEL WAGNER and CHRISTINA REXRODE]

Rexrode reported from New York.

Daniel Wagner can be reached at http://twitter.com/wagnerreports.

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