When Stocks Might Hit New All-Time Highs

Even though the economy is sputtering, some forecasters think stocks are set to rally.

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It's a bit of a puzzle: The U.S. economy is weak, Europe is close to a recession and there are a number of other things that could go terribly wrong. Yet stocks have been inching higher and are getting close to peaks last attained in 2007, before the Great Recession knocked them down.

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So Wall Street analysts are starting to ask a daring question: What will it take for stocks to reach and exceed their prior highs?

The S&P 500 index peaked in October 2007, two months before the recession officially started, at 1,565. Today the S&P 500 is around 1,460, about 7 percent below the peak. The tech-heavy NASDAQ composite has already exceeded its 2007 peak (though it's still far below levels of early 2000, which was the end of the dot-com bubble). Lesser known indexes, such as the S&P Small Cap 600, have even recently surpassed their all-time highs.

So are good times on their way back? Or are recent stock gains a mirage conjured by central-bank stimulus measures and other temporary factors? Maybe a little of both.

The Federal Reserve's latest round of quantitative easing—dubbed QE3—clearly gave a boost to stocks that would probably be languishing without Fed action. The S&P 500 has risen by about 9 percent since the middle of July, even though economic indicators over that time have generally shown that the economy is slowing. Since quantitative easing tends to boost stocks, the market rose on the expectation of more Fed easing. When the Fed actually did it, stocks rose more, because the Fed's new program was more aggressive than anticipated.

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With the boost from QE3 now in the past, stocks could flatline over the next several weeks, especially if the economy continues to slow. But some prominent forecasters think the upward march will continue, even if it's a jagged climb. Bank of America Merrill Lynch, for instance, thinks the S&P 500 will hit a new all-time high sometime in 2013, and end next year around 1,600.

Investing firm Piper Jaffray is even more bullish, predicting that the S&P 500 will hit 1,700 within 12 months and 2,000 within 24 months. That would be a nifty 37 percent gain over two years.

There are some speed bumps in the way of this forthcoming rally, however. In a recent note to clients, Merrill Lynch listed several factors that may hold stocks back over the next few months, such as the uncertainty over who will win the November elections, and what Congress will do about the "fiscal cliff," a set of big tax and spending decisions that must be made by the end of the year. Until businesses and consumers know the outcome of those events, they're likely to put off their own economic decisions as much as possible, depressing economic activity.

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More clarity about who will be running the country for the next four years—and the government's own financial situation—could unleash some fundamental economic trends likely to boost profits, hiring and stocks. The biggest is housing, which finally seems to have bottomed out. Up till now, housing has been a drag on the economy, which helps explain why the recovery has been so weak. But Merrill Lynch expects home sales and new-home construction to finally rebound toward normal levels in 2013, which would make housing a source of growth. That's what's supposed to happen in a recovery.

Big companies may also hit a soft patch in earnings in the third and fourth quarter of 2012, thanks to a worldwide economic slowdown and worries about end-of-year political chaos in Washington. But that too could ease if Washington gets its act together and 2013 starts off with a few things going right.

As always, there's plenty that could disrupt this optimistic scenario. One way Washington could avert the fiscal cliff is to simply put off the day of reckoning on which tax hikes or spending cuts will go into effect. That would provide some breathing room for the economy, which may not be ready for such austerity measures. But it could also lead to further downgrades in the U.S. credit rating if there's no plan to address the mushrooming national debt.

The last time that happened, in the summer of 2011, investors shrugged it off and nothing really changed about America's ability to borrow. That could happen again. But every downgrade will bring the U.S. government closer to a crunch point at which investors may lose confidence in Uncle Sam and start to demand higher rates to loan America money. At some point, higher borrowing costs could be the thing that triggers a bona fide debt crisis.

Then there are the usual worries, such as a Middle East war involving Iran or other countries, and a chaotic breakup of the euro zone. But investors have been digesting those sorts of risks for a while, and have learned to take them in stride. There's always something that can go wrong, but you have to prepare for things going right, too.

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