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This One Goes to Thirteen

Falling oil prices, a halt in interest-rate hikes, and a wave of hedge-fund buying sent the Dow above 12,000. Now they’ll take it higher.

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Illustration by Marc Boutavant  

Go ahead, dismiss Dow 12,000. Virtually everyone I know on Wall Street will tell you to do so: “Small-time index, relic of another era, not important to signal a change.” To which I say, “Nonsense.” The Dow is not only the most representative snapshot of the American economy, but the venerable, oft-quoted index is still the one that entices people into the market. The broader averages will now follow the Dow higher, perhaps much higher, because after six years in purgatory courtesy of everything from dot-com bombs to cooked books to crooked research to hidden option paydays, Wall Street’s back making people fortunes again. Except this time, it’s not just the bankers. It’s everyone who owns name-brand stocks. The additional cash flowing in, like the first trickles of water seeping through a fissure in a dike, could turn into a torrent now that we’ve taken out that benchmark.

How did we get here? More important, why am I so certain that there’s much more ahead? Because we’ve had an awesome number of things go right in the past year, and the trend—always your friend on Wall Street—points to more of the same in the coming months.

The concoction that lifted us to 12,000 is a mighty, strange brew—a bullish recipe that includes one part lower oil and housing prices and stabilized interest rates; one part higher corporate profits; and one part incredible negativity of big-time money, including many of the hedge funds out there (I’ll explain the role they play in a minute). While some of these factors may eventually reverse themselves, don’t count on any of them going away in the near future.

To understand why this rally has staying power, you need to get beyond the obvious negatives, at least to Wall Street, of a potential Democratic sweep in Congress, a constant worry of terrorism, and a president paralyzed by the morass in Iraq. First, just four months ago, traders were petrified that gasoline at $3.25 would go to $4.25 and that the economy could be crushed by it. Consumers had vanished from stores and restaurants; car sales plummeted. A recession seemed to be just months away. At the same time, the slowdown in housing became an outright stoppage, with home sales plummeting and inventories climbing to levels not seen in fifteen years. With that glut so visible, those still holding on to the belief that property could trump stocks finally gave up the real-estate dream, and the Federal Reserve, determined not to be the cause of a recession, put its relentless increase in interest rates on hold at last.

With the Fed on hold and housing losing all luster as an investment, the unthinkable occurred: Oil dropped almost $20, and gasoline fell by more than a quarter. Consumers flooded everything from Wendy’s and Red Lobster to JCPenney and Nordstrom, and on Wall Street that translated to “upside surprises” against lowered earnings estimates. No one cares about how earnings forecasts get beat—even if they’re reduced by fleeting factors like a cessation in rate hikes or gasoline declines. The better-than-expected earnings quickly fueled higher stock prices. When you consider that of the 30 industrials in the Dow Jones, only one, ExxonMobil, gains from higher oil prices and 29 gain from lower ones, you can see why the move had oomph. And when you consider that almost no Dow stocks get hurt by lower housing sales but all benefit from the declining interest rates that a slowdown in housing causes, you know the oomph’s going to be turbocharged.

All that good news wouldn’t have mattered if stocks were expensive. But we’ve seen years of pretty decent earnings for companies without much of an uptick in stocks. That’s because 29 of the 30 stocks in the Dow have had buybacks, some of them huge (and some ongoing). Only General Motors hasn’t had one (and that’s the only Dow stock that actually needs cash). The rest just throw off scads of the stuff. These buybacks are literally shrinking the supply of stock out there dramatically. When the buyers came in, courtesy of the declines in oil and housing and the flattening of interest rates, there wasn’t enough stock to go around, forcing buyers to move stocks up to get them. The companies that had bought back the most, Hewlett-Packard, Coca-Cola, AT&T, IBM, and Microsoft, have been responsible for much of the gain we’ve had.

It’s questionable, though, whether the upward move would have the velocity it has if it weren’t for another group of buyers: the hedge funds. The managers of these funds pride themselves on betting against, not with, stocks, and the declines since the May 10 peak in the averages were a license for these shorts to print money. But the swift decline in gasoline caught the hedgies with their shorts up and, they, too, had to scramble to buy, lest their negative bets wipe them out. Their purchases squirted acetylene on an ¬already roaring fire.


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