Why the Stock Market Is Going Up

It's a stock-market conundrum: The economy is barely growing, oil prices keep climbing, housing remains in a funk -- and yet stocks are rebounding.

Wall Street often goes in a different direction from Main Street, of course, largely because stock prices are bets on the future value of companies, as opposed to a report card on their operations and profits today. The market can climb when the business environment is rough, if there are signs that the future looks more promising.

But now -- with the Dow Jones Industrial Average up 11% from its March low, after a 1.9% gain last week -- it's too early to say the economic outlook is brightening. Financial pressure is growing on consumers. And corporations aren't looking much better: First-quarter earnings for companies in the Standard & Poor's 500-stock index dropped 26% compared with the same period last year, the third consecutive quarter of falling profits, something not seen in almost seven years.

It all means that investors shouldn't throw caution to the wind.

A Relief Rally

Behind the recent stock-market strength: relief that the economy isn't collapsing and hope that the downturn will be short and shallow, followed by an upturn in the next six months or so.

Aggressive steps by the government -- including lower interest rates, low-cost loans to investment banks and fiscal-stimulus checks in the mail to millions of Americans -- have helped keep the financial system afloat and could re-energize the economy, bulls say.

"The economy has not turned out as bad as most feared," says James Paulsen, chief investment officer at Wells Capital Management. "The unemployment rate is still low, job losses are much less than past recessions and profits -- outside of banks -- have remained stronger than thought."

Last week's advance by the Dow industrials narrows their year-to-date drop to 2.1%. The Nasdaq Composite Index gained 3.4% last week, trimming its 2008 loss to 4.7%.

Still, Jason Trennert, chief investment strategist and managing partner at Strategas Research Partners, doubts that the economy and the market are out of the woods.

"The need for consumers to repair their balance sheets," by cutting spending and debt, "probably means the recovery will be a mirage," Mr. Trennert says. "If one believes the economy will experience a double-dip recession -- as we do -- the current rally, although strong, could fade as we enter 2009."

Many hedge funds and other sophisticated investors also remain wary, and some are building up cash reserves, concerned that the current economic doldrums may last longer than many anticipate.

The weakness in corporate profits has been partly offset by a weakening dollar -- which makes U.S. goods less expensive to foreign buyers and inflates earnings booked outside the U.S. But the greenback has been rallying a bit, amid signs that the Federal Reserve's interest-rate cuts may be on hold.

Avoid Treasurys?

The best course for investors, according to a number of advisers: Ditch the safest investments, which don't do well as hope returns to the market.

Investors should "stay away from high-quality bonds" such as U.S. Treasurys, Mr. Paulsen says, because their yields are not high enough to provide ample compensation. He's also wary of energy-related shares, which have soared this year but aren't as attractive if the dollar stabilizes.

It's also likely too early to get aggressive and buy financial shares, which could see another leg down, many advisers say.

Strength and Growth

Instead, investors should focus on well-run companies with impressive growth outlooks, especially those focused on foreign economies likely to continue growing.

Both Mr. Paulsen and Mr. Trennert are fans of technology shares. Mr. Trennert notes that tech companies have "tons of cash and very little debt, and may be the biggest surprise outperformer."

Spending by corporations, such as in the telecommunications world, remains resilient. That's one reason analysts at Goldman Sachs call Amdocs a "must own" stock. The company provides customer-care and billing services for telecom companies, among other businesses. The stock has fallen in the past year but now trades for about 13 times next year's expected earnings, a reasonable level. The company is expected to grow profits 17% in the next year.

Other analysts like Terra Industries, a leading producer of nitrogen used for fertilizer. It has seen soaring profits and cash flow as more farmers plant corn to take advantage of higher corn prices. Terra recently expanded a share buyback program and initiated a dividend. And even though the stock is up a heady 140% in the past year, it's still trading at less than 10 times its expected earnings for the next 12 months.

Another reasonably priced stock seeing growth abroad is Eaton, an industrial-equipment maker that's expected to see a 21% rise in profits over the next year.

Jack Ablin, chief investment officer at Harris Private Bank in Chicago, advises investors to favor discount and mid-tier retailers, such as Wal-Mart Stores and Family Dollar Stores, rather than upscale stores like Nordstrom, Coach and Ralph Lauren, in part because stimulus checks aren't being sent to wealthier consumers.

"It's unlikely many of these checks will turn up at Tiffany," Mr. Ablin says.