March 5, 2013

Dow hits record, erasing Great Recession losses

The Associated Press

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Trader Peter Tuchman smiles as he works on the floor of the New York Stock Exchange on Tuesday. The Dow reached a new high Tuesday.

The Associated Press

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The rich have been the biggest winners of this bull market. Eighty percent of all stocks are held by the wealthiest 10 percent of households.

The question now: Can the stock rally continue? Here are four reasons it could:

Plenty of cash: Companies have enough money to keep buying shares, which can push stocks up in the short term. Companies in the S&P 500 had more than $1 trillion in cash late last year, two-thirds more than in 2007.

Low inflation and interest rates: Two factors that typically spell the end of a bull market seem a long way off. Inflation has been 1.6 percent the past 12 months, below the Fed's 2 percent target. Interest rates are near record lows; the short-term rate the Fed controls is being kept between zero and 0.25 percent. The Fed has said it plans to keep the rate where it is until unemployment falls below 6.5 percent, or 1.4 points lower than it is today. Even when the Fed starts raising the rate, it could be years before it gets high enough to hurt the economy and stocks.

Four of the five previous bull markets since 1970 ended as investors got spooked by a recession, or the anticipation of one, and sold stocks. And what causes recessions? In three of the past five, it was the Federal Reserve hiking interest rates to slow inflation.

Economic expansion: The economic expansion that began 44 months ago in June 2009 is still relatively young. The previous three expansions lasted 73, 120 and 92 months. And this one may finally be getting traction: Sales of new homes in January hit the highest rate in 4 ½ years. Home prices in January were up nearly 10 percent nationwide from a year earlier. And sales of autos, the second-biggest consumer purchase, reached a five-year high.

Most important, hiring is picking up. Employers added an average 200,000 jobs each month from November-January, compared with 150,000 in each of the prior three months. More jobs means more money for people to spend, and consumer spending drives 70 percent of economic activity.

Stocks still seem reasonably priced based on the earnings that companies are generating. On average, stock prices are 17.5 times per-share earnings in 2012 versus 19.4 times in 2007. Today's price-earnings ratio is the same as the average since World War II.

If per-share earnings keep growing, stock prices could go up too, and the P/E ratio would stay the same. And there have been many periods in which P/E ratios rose well above the long-term average. Such "multiple expansion," as market watchers refer to a rising P/E ratio, would mean stock prices would be even higher.

To stock bulls, the economy is on the verge of what Bernanke calls "escape velocity," a self-sustaining pace of growth and better than the sluggish 1-2.5 percent of the past three years. Faster economic growth would boost corporate earnings, which would lead to higher stock prices.

Of course, if investing was as simple as looking up interest rates and stock valuations, we'd all be rich. Plenty can go wrong.

For starters, future earnings, the biggest driver of stock prices, could prove disappointing. Financial analysts expect earnings for the S&P 500 to grow a healthy 8 percent this year, according to FactSet, a provider of financial data. Most of that increase is expected in the last half when they assume economic growth accelerates.

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