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Analysis: In a crummy economy, why are stocks rising?

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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, this 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.

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 down interest rates, which encourages spending, and drive up stocks, which makes people feel richer.

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 June 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 work force 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 single 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 separate 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 previous 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."

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  • Wolf in sheeps clothing
    So this administration is making stocks the most attractive investment vehicle. Hmm. So if obama wants to equalize wealth the easiest way would be to make those with wealth less wealthy. And wouldnt a stock market crash do that in one fell swoop?! Congress could not prevent bernake from suddenly reversing course and make stocks poison. Be afraid, be very afraid if obama wins in november.
  • I'm not better off than I was 4 years ago
    I don't care what the media, Ben Bernanke or either presidential candidate says or does - I make less, work harder and things (insurance, gas, food, etc.) are all much higher. Am I still middle class???
  • Things are better
    Housing prices are up. Home sales are up. Banks are lending money. Many public companies are making profits Q-over-Q, and doing so without hiring more people. If the recession did anything, it helped large public companies realize that they were over staffed, thus most companies have been slow to add people. Education is the key factor. College grads are close to 4.5% unemployed, while high school dropouts are close to 25% unemployment. Minimum wage jobs are the future for anyone who feels that a high school diploma is all they need.
  • The Economy
    I believe the economy is never going to recover if the media keeps feeding the population with "the crummy economy" "the bad economy" "the dragging economy" if the media will just stop feeding that mindset it would be better.

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