Stocks Rise, for the Wrong Reasons

A conflicted Wall Street debates whether stocks are artificially inflated, or headed for a surge.

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It's usually encouraging when the stock market rises, since that makes big companies more stable, boosts retirement plans, and generates optimism.

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Except when everything else is going wrong.

In general, the stock market rises with a growing economy, but there are times when the market decouples from the real world and rises for other reasons. Now seems to be one of those times. The S&P 500 stock index is up a snappy 12 percent since June, and it recently hit the highest level since mid-2008, before the financial crisis erupted. The technology-heavy Nasdaq index recently hit its highest level in 12 years.

Yet this has happened while growth has been slowing, the outlook for corporate profits has been fading, and election-year politics threatens a standoff in Washington that could harm the entire economy.

What's pushing the markets up isn't optimism about the economy, but hopes for a rescue. Several rescues, in fact. One of the biggest factors in the stock run-up this summer has been the expectation that the Federal Reserve will roll out more quantitative easing, which tends to push down long-term interest rates. That forces investors out of safer vehicles like bonds and treasury securities and into riskier assets like stocks. So as demand for stocks rises, prices do too.

The Fed now seems likely to announce more easing soon, on account of a weak August jobs report and other signs that the economy needs help. "The economy remains very weak and is not likely to improve any time soon," says Russell Price, senior economist at Ameriprise Financial Services. "The odds of the Fed offering another large-scale stimulus program are now higher."

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This comes after the European Central Bank announced that it, too, would embark on a form of quantitative easing, by buying government bonds as a way to reduce the financial pressure on strapped nations such as Spain and Italy. "The recent economic and earnings news has clearly been disappointing," writes Dick Green of Briefing Research, "but has not bothered traders so long as central banks are perceived as providing liquidity support."

Stocks have gotten a further boost from China, where the government just announced stimulus measures totaling about $190 billion, to help spark the cooling economy there. That signals even more government intent to artificially bolster growth.

Rescues, however, can't float the stock market indefinitely, and investors buying equities hoping for short-term gains linked to government action are likely to sell when they feel the intervention has run its course. So the real question about the stock market is how long the Fed and its allies overseas can keep pumping helium into it, and what will happen when the flow gets cut off.

Skeptics worry that central-bank stimulus—a sophisticated form of printing money—will lead to runaway inflation that forces a prompt halt to monetary easing. That hasn't happened yet, obviously, but if it does, the result could be a prolonged slump in stocks as artificial support disappears before the real economy is back on its feet. Those worries have been amplified by recent cutbacks in the sales forecasts for several big firms, including bellwethers such as Intel and FedEx.

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But others feel there will be a strong and sustainable recovery starting in 2013, once the U.S. elections are over, Congress deals with a huge set of tax and spending decisions that must be made by the end of the year, and Europe makes a more determined effort to keep the euro zone glued together.

Investing firm Piper Jaffray, for instance, predicts that the stock market will rise by nearly 20 percent over the next 12 months, and by nearly 40 percent over two years. "The popular averages are all in the early stages of an uptrend," the firm's strategists wrote in a recent report to clients. If they're correct, something needs to go right in the real economy pretty soon, other than government agencies stepping in to help.

Rick Newman is the author of Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.