Optimism returns to markets

Prospects for 2006 and hopes for steady interest rates pushed the Dow above 11,000 Monday.

The stock market, often considered a barometer of how investors feel about the economy's prospects, is now reflecting an optimism not seen in years.

The main catalyst for the surge is the expectation that the Federal Reserve is close to its last interest-rate hike, which could make stocks more competitive than bonds. At the same time, the real estate market is slowing. Many Americans had moved assets there after the dotcom bust, but now, stocks are beginning to entice some back.

In more good news for investors, analysts expect the economy to run at a moderate pace without inflationary stresses and strains.

"It looks like we're back to the Goldilocks economy: It's not too hot, not too cold," says Alec Young, a market strategist at Standard & Poor's in New York. "The stock market hasn't looked this good in a long time."

The optimism has carried the Dow Jones Industrial Average past 11,000 for the first time since June 7, 2001. On Monday, the Dow closed at 11,011.90. The rally actually started in October, when some investors began to anticipate that the Fed would stop raising interest rates this year. Since then, the Dow has risen about 750 points.

The last time it closed at this level, investors had pushed up the price of Enron stock to more than $50 a share. And neighbors bragged about how much their mutual funds had gone up - not how much they made flipping condos in Miami.

The underpinnings of the stock market were quite different. Earnings are now about 50 percent higher than they were in June 2001. Dividends are 40 percent higher. And the stock market's valuation, based on its future earnings prospects, has considerably less fluff in it.

"This market looks better at 11,000 than the market did in 2001 when it was at this level," says Jeff Kleintop, chief investment strategist at PNC Advisors in Philadelphia. "Overall for the market, earnings are strong and valuations and balance sheets healthier."

Cautions on exuberance

Of course, investors have to be prepared that the stock market - or those guiding it - change course. "Things may not be as rosy as we are made to believe," says Axel Merk, manager of the Merk Hard Currency Fund in Palo Alto, Calif. "Some of the retailers didn't have such a great season, and there are doubts about their earnings. Oil is once again over $60 a barrel, and the Fed may not be done tightening."

Mr. Merk points out that so far, all the Fed has done is "talk." In releasing last Tuesday the minutes of its Dec. 13 meeting, the Federal Reserve indicated that most members of the committee that sets interest rates felt "the number of additional firming steps required would probably not be large."

Immediately after the release of the minutes, the stock market raced higher.

Merk, who mainly invests in gold and currencies other than the dollar, says, "I'm not sure everyone read the entire statement. It includes words like vibrant and brisk, words not usually associated with the end of tightening."

However, Mr. Young says the Fed's statement "is as close as you can get to an admission that there is light at the end of the tunnel."

In his view, the Fed's actions will come at a time when he expects the economy to grow at a respectable 3.4 percent. Core inflation - the inflation rate without food or energy prices included - will rise 2 percent compared with last year.

Energy prices, which have been a worry on Wall Street all year, are back up, with oil selling at close to $64 a barrel. But this time, investors appear to be a little less concerned, even though high energy prices act as a tax on consumers.

"We are at the point in the economic cycle where business investment is more important than consumption, and business is feeling good about itself and the economy," says Bob McIntosh, chief economist at Eaton Vance, a Boston-based mutual fund company.

What drives the 'January effect'

This optimistic view of the economy comes at a time of the year when the stock market has historically gotten a lift, something investors term the "January effect." Many bonds pay interest in January and June, giving investors extra money. Professional investors reassess their portfolios and make changes. This year, there are several trillion dollars in money-market accounts - funds that are available to be moved into the stock market.

In addition, the stock market faces less competition from the bond market. Long-term yields are so low that the dividend on some stocks is higher than the yield on the 10-year Treasury bill. "The six-month and 10-year bonds have the same yield, which makes equities the asset class of choice," says Young.

Even though the stock market has improved, the atmosphere has not reached the levels of the late 1990s, when many Americans were checking their accounts each day.

On Monday, at Grand Central Terminal in New York, a variety of individuals said that the rising stock market, while good, did not particularly affect them. "I don't work in finance and don't have a lot of investments in stocks," said Jim Locovare of Larchmont, N.Y. "Our house is absolutely our most important investment."

Even those who do invest in the market are not overly exuberant. One of those is Ann Brown, a real estate agent from Scarsdale, N.Y. She says she and her husband are happy that the market is rising since they invest their profits from buying and selling homes in the stock market. But, real estate "has been better than investing in stocks," she adds. "It never went down."

Dow's ups and downs

Investors rode a wave of enthusiasm generated last week after the Federal Reserve signaled it would soon stop raising interest rates - pushing the Dow Jones Industrial Average above the 11,000 mark Monday. Below is a recent history of Dow performance.

Five-year low: The Dow stood at 7,286 on Oct. 9, 2002. It has gained about 50 percent since then.

All-time high: The Dow hit 11,723 on Jan. 14, 2000. As of Monday, it was 6.1 percent below that peak.

This year: The Dow is up 294 points, or 2.8 percent.

Source: The Associated Press

Alyssa Work in New York contributed to this article.

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