Six years later, the Dow is back

Without much fanfare, the Dow Jones Industrial Average is closing in on its all-time high, set at the beginning of 2000 before Americans became disenchanted with stocks and turned to real estate.

Despite soaring oil prices, the Dow, watched as a barometer of the economy and Main Street, has regained more than 4,000 points that slipped away after the dotcom bust and the 2001 recession. Now, the average is closer than it's ever been to its Jan. 14, 2000, high of 11,723 - a number that brings back memories of taxi drivers talking about their stock portfolios and a book predicting a 36,000 level for the Dow.

Behind the rebound is a solid economy, emphasized last Friday when the Commerce Department reported that the nation's gross domestic product grew at a swift 4.8 percent, the best growth in 2-1/2 years. Indeed, the healthy economy is pumping up corporate earnings, which have been growing at double-digit rates. Some of the fastest-growing engines of economic growth are at the nation's smallest companies, whose stocks have averaged about a 20 percent gain per year for the past five years.

Some analysts expect the next leg in the economy to be powered by the capital spending of cash-rich companies.

"The economy is fundamentally sound," says Scott Brown, chief economist at Raymond James & Associates in St. Petersburg, Fla. "Even though economists have been expecting the economy to slow, recent data suggest it's not that soft."

Last week, companies from Chevron to Microsoft to GlaxoSmithKline reported healthy earnings increases. "The last few years, Wall Street analysts have continued to underestimate earnings, and that's true today. The majority of companies are beating the estimates," says Art Nunes of IMS Capital Management in Portland, Ore.

One reason is that even though times are good, US companies still act as if they might have to close their doors tomorrow, squeezing productivity gains out of their machines and workers. This was evident again last Friday, when the government reported that wage and salary growth was flat in the first quarter despite a relatively low 4.8 percent unemployment rate. "After the big recession, companies really pulled in their horns, trimmed their capital expenditures, became leaner and meaner," says Mr. Nunes.

In addition, reforms enacted in the wake of the Enron scandal and other corporate lapses have helped boost Wall Street's confidence in profit-and-loss statements. For example, the Sarbanes-Oxley Act mandates more corporate accountability in earnings reports. "The Sarbanes-Oxley legislation maybe brought some confidence back," says David Chalupnik, head of equities at First American Funds, which manages $90 billion in investments. "The market's been solid ever since."

The market has also avoided "irrational exuberance," as former Fed Chairman Alan Greenspan termed the go-go 1990s. One key indicator is the price-to-earnings ratio: A lower ratio signals a more conservative investment outlook. Mr. Chalupnik says the market is currently selling at a price-to-earnings ratio of about 16 times earnings, compared with a more typical 18 times earnings. "If we go back to 17 times earnings for the Standard & Poor's or the Dow, prices would be about 6 to 7 percent higher than today," says Chalupnik. "That gives you a normal market return."

However, other analysts point out that the dynamics facing the economy are also starting to change. The Federal Reserve has raised interest rates 15 consecutive times. Next week, it is expected to hike rates another quarter of a percent.

"The engine for the recovery was cheap money, which fueled housing, which fueled borrowing, which fueled home equity and allowed people to take the cash out in home-equity loans for goods and services," says Jim Svinth, chief economist at LendingTree.com, an online mortgage lender based in Irvine, Calif. "There is always a lag in monetary policy in getting back to the consumer, and it will probably take six to 18 months for this to work its way through."

Others worry that the Fed may not be done raising rates. Ben Bernanke, the new Fed chairman, has indicated that the Fed may pause after it probably raises rates next week. But he hasn't ruled out raising them again in the future. "Factor in that the Fed may not be done, higher-than-expected energy prices, and a consumer who is stretched, and it does give us cause for concern," says J. Michael Barron, CEO of Knott Capital in Exton, Pa.

The market is trying to "sort through a lot of data" to determine the shape of the economy in the future, says Mr. Barron. "If the Fed has to cut interest rates next year, it will mean economic growth is slowing, and the question for stock investors is what does that mean for future earnings streams," he says.

Some market watchers point out that stocks have been rising in the face of the Fed ratcheting up short-term interest rates for some time. At least over the near term, that will continue, they believe. "We're bullish on the market over the short term. The economy is good, inflation is low, and earnings growth is terrific," says Chalupnik. But he adds, "What has changed is that long-term interest rates have started to move up, and that should start to affect economic growth. We are concerned that the expectations for the market for the second half of the year are too high."

But other stock-market players maintain that interest-rate movements are irrelevant for long-term investors. "Corporations worry about China, inflation, interest rates. They sell off parts of a company if they're not making any sense," says Jim Cullen of Schafer Cullen Capital Management in New York. His firm is known for "value" investing - that is, finding companies that the market may have overlooked. "As an investor, you just to make sure the corporate managers are halfway on the ball."