In a crummy economy, why are stocks soaring?

Associated Press Modified: September 16, 2012 at 11:45 am •  Published: September 16, 2012
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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."

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