For Stock Investors, Bad Economy Isn't Bad

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The Dow Has Jumped Past 10000 Again as Uncle Sam Pumps Cash Into Financial System

First the bad news: The economy is weak.

And now the good news: The economy is weak.

Oddly, the same problem that worries many investors over the longer term is what encourages some for the short term: a soft economy. The reason is that an ailing economy requires the Federal Reserve to keep its short-term interest-rate targets near zero and continue pumping billions of dollars into the financial system.

That is great for stocks because much of that money eventually finds its way into financial markets, and because cheap money keeps financing costs low and pushes corporate profits higher.

On Thursday, the stock market surged in response to Wednesday's Fed announcement that it would keep rates low. On Friday came news that unemployment had jumped to 10.2%, and stocks actually rose some more. Worries about whether government intervention would be enough to keep the economy growing have been one of the reasons behind the series of volatile up and down swings in late October and early November.

The Dow Jones Industrial Average closed Friday at 10023.42, up 3.2% on the week, and 14.2% for the year-to-date.

Economists at Morgan Stanley measure the amount of cash circulating in the global economy as a percentage of total economic activity. Large money injections by the world's central banks have pushed that gauge to its highest level by far since Morgan Stanley began tracking it 30 years ago.

So while the basic economic motors such as sales, employment and credit remain on life support, the continued expansion of cheap money means that a basic pillar of the stock market remains in place.

Some investors worry that, one day, all the intervention may lead to unsustainable deficits or new bubbles in junk bonds, developing-country stocks or commodities. But that is a problem for later.

"First, we enjoy our dinner. Later come the after-dinner speeches," says David Kotok, president of money-management firm Cumberland Advisors in Vineland, N.J. "We have a period ahead of us of low interest rates. Markets love that." He is heavily invested in stocks and says the market can keep rising at least into spring or summer of next year. He believes corporate cost-cutting could continue to lead to higher-than-expected profits even on modest sales improvement.

Plenty of investors see things differently. Some are deeply pessimistic, believing that huge government deficits and borrowing will end the market recovery soon and lead to severe inflation or, if the stimulus is withdrawn too quickly, deflation. Others are optimistic, believing that the economy and stock market are entering a long-term recovery that will confound doubters.

A surprising number are caught in between, worried about what comes later but trying to profit for now.

Market veteran Steve Leuthold of Leuthold Group in Minneapolis, who has been bullish for months, worries now about deficits, potential downward pressure on the dollar, eventual inflation and the risk that it could take a "dramatic crisis for this country to regain its fiscal integrity" some time in the next four years. But not yet.

"There seems to be a growing consensus that the S&P 500 is going to 1200 in this quarter" from 1069.30 on Friday, he writes. "I expect a surprisingly profitable Christmas season for many retailers with less competition, firmer pricing and a moderate uptick in consumer spending."

He says he is starting to make some adjustments to his portfolio to protect against a potential future crisis, but for now his portfolio continues to hold high levels of stocks.

Recent decades have provided a lesson. Low interest rates can produce prosperity, but if they stay too low for too long, they can lead to pain.

A recent example was the long-running bull market from 1982 through 2000. Severe inflation had held stocks down in the 1970s. The Fed broke inflation by pushing its overnight interest-rate target to 20% in 1981. With inflation finally waning, it could cut interest rates steadily, fostering extended economic growth and stock-market gains.

That long bullish period finally ended in 2000, and some investors blamed the Fed for allowing rates to become too benign and money too cheap, permitting bubbles in technology stocks and, later, real estate.

Rate cuts from 2001 through 2003 helped create a bull market into 2007, but those gains were wiped out in less than two years.

In a recent letter to clients, strategist Richard Cookson of HSBC compares the economy's dependence on debt with a heroin addiction. He compares recent central-bank stimulus with methadone: unavoidable, perhaps, but putting off a cure until later.

Ned Davis, founder of Ned Davis Research in Venice, Fla., worries that the U.S. is in for a Japan-like period of high deficits and fizzling stock rallies. "In the long run, this easy-money policy is likely to just postpone the pain for the bulls, and easy money usually does not end well," he wrote in a recent commentary. For now, however, he is heavily invested in stocks.

Investors over the next few months are likely to become fixated on Fed signals about what it intends to do with rates.

First, the Fed will start modifying the language in its regular policy statements, gradually raising the prospect of an end to cheap money. It will ease up on the bond purchases it uses to inject cash into the economy. Finally, it will raise rates.

As that process develops, the risk of a significant stock decline will grow, along with investor fears. That will come amid hand-wringing about whether the Fed is acting too quickly or too slowly. Given recent experience, central bankers and investors alike will be anxious about the risk of a bubble and the risk of acting too soon and sending the economy back down, as the Fed did in the late 1930s.

"It puts central banks in a very, very difficult position because you don't want to hike before the recovery is entrenched, but you also don't want to have another asset bubble," says Morgan Stanley economist Spyros Andreopoulos.

Write to E.S. Browning at jim.browning@wsj.com