An Uneasy System

Stocks Are on the Rise Even as the Economy Loses Steam

The Standard & Poor's 500-stock index reached a record Friday after a report on job growth exceeded forecasts. (By Ramin Talaie -- Bloomberg News)

The economy is slowing, the dollar is falling. Wall Street is laying off workers. Defaults by homeowners are rising. Corporate buyouts have lost momentum.

But none of it has rattled stock market investors. Just weeks after the shock of the summer credit squeeze, they are shaking off one bad report after another, sending shares ever higher. Call them the Teflon investors.

On Monday, the Dow Jones industrial average of 30 blue-chip stocks soared to a new high, even as two major investment banks announced that they lost billions of dollars in the credit market turmoil. Then a positive jobs report Friday gave investors an excuse to buy, and the Standard & Poor's 500-stock index, a broader market measure, surged to a record. But even as investors celebrate, the questions hovering over the economy's future are far from settled.

If you're scratching your head about the seeming disconnect between stocks and the economy, you're not alone. The stock market, after all, is supposed to be a leading indicator of economic performance.

So what's going on? Does the stock market know something the rest of us don't?

The answer, analysts say, lies in a mix of investor optimism about a responsive Federal Reserve, an upbeat outlook for the global economy and not-so-gloomy reports about how badly the credit crunch has affected companies and the U.S. economy.

"The dynamic of the market right now is, 'Yes, we acknowledge there are problems in residential real estate. We acknowledge there are problems in the mortgage industry. We acknowledge that there continues to be tightness in the credit market,' " said Arthur Hogan, chief market analyst at Jefferies & Co. "But not withstanding those issues . . . there's a perception that with a friendly Fed, and no signs of increased spillover from what's happening in residential real estate and the credit markets to the broader economy, that earnings growth can still be robust going into 2008."

But the wild summer, if anything, has shown how fragile such perceptions can be.

The third quarter kicked off strong, continuing a giddy spring during which investors snapped up riskier assets such as shares of small companies and low-quality corporate debt. The Dow closed above 14,000 for the first time July 19 despite signs that easy access to credit, the engine of the economy in recent years, was drying up.

But soon, mounting evidence of weakness in the lending market became too much to bear, and fear overtook all aspects of investing. Stock prices plummeted. Corporate dealmaking ground to a halt.

On Aug. 9, central banks around the world began pumping money into the financial system to keep it operating smoothly. Among them was the Fed, which just days earlier had appeared more concerned about inflation than a credit crunch. With markets still unsteady, the Fed on Sept. 18 cut a key interest rate by half a percentage point, prompting an end-of-the-quarter rally in stocks. The rate influences other short-term rates, including those on credit cards and many business loans.

The Dow, despite falling as much as 10 percent from its all-time high during the credit crunch, finished 3.6 percent higher for the quarter and is up 12.9 percent for the year as of Friday. The S&P 500 rose 1.6 percent for the quarter and is up 9.8 percent for the year. The technology-heavy Nasdaq composite index rose 3.8 percent for the quarter. It is up 15.1 percent year to date.