Stock markets will ring out one of their most volatile periods in history Thursday with an incredible rally that replenished half the losses caused by the financial crisis.
While the Dow Jones industrial average zigzagged through the last 10 years to finish near its start, 2009 proved to be the best year after the comeback in 2003, which followed another epic crisis, the dot-com bust.
The Dow Jones industrial average will probably end the year up more than 20 percent, and the broader Standard & Poor’s 500-stock index nearly 25 percent. Shares of troubled banks such as Bank of America, which tumbled more than 90 percent when markets were packed with fear, are resurgent after repaying billions the government lent them to make it through the crisis.
But whether investors continue to see these gains will depend on more than an economic recovery.
As the recession ebbs, interest rates are expected to rise in 2010, weakening the fragile rebound that is emerging in corners of the housing market. Unemployment may be peaking, but many Americans are still struggling to pay bills, or even avoid foreclosure. And the government is starting to pull back on the cheap financing it used to stimulate the economy and nurse the financial industry back to health.
If recent signs of growth fizzle out, markets could once again lose their ebullience, as they have several times in the last two years. A solid recovery would push stocks higher, though few analysts expect the market to repeat its stunning 2009 performance.
"There are long, long periods of time when the market and the economy go two different ways," said Barry Ritholtz, a professional investor and author of "Bailout Nation," a book about the causes of the financial crisis. "A rallying market doesn’t necessarily mean the economy is healing."
For much of the decade, the stock market has been a great disappointment. As of Wednesday, the S&P index closed 23 percent below and the Dow closed 8.25 percent below where they ended 10 years ago, in 1999. The Nasdaq, the average hit hardest by the bursting of the dot-com bubble, is down 44 percent.
How markets will look in the coming decade will be determined in part by policymakers. A too-rapid withdrawal by the government of financial or monetary support could throw markets into fresh tumult. But if policymakers take too long to let go, they could help to re-inflate bubbles in stock, housing and other markets.
"If things are booming, policymakers will feel empowered to remove stimulus quickly," said Marc Stern, chief investment officer at Bessemer Trust, an investment firm in New York. "If you are an investor, what you actually want is the Goldilocks phenomenon — not too hot, not too cold."
For now, many investors are starting to believe that the painful 10 years just concluded has laid the foundation for a new bull market, just as the misery of the 1930s was followed by a postwar boom. These optimists say the worst of the financial crisis is over now that the big banks are making money once again.
Although the economy remains weak, their argument goes, it is growing again. Inflation remains tame, and interest rates are low. Fewer jobless claims are being filed, and some companies are starting to hire again. Industrial activity is showing sparks of life, while a weak dollar has helped American companies sell more overseas, especially to emerging markets such as China and India.
"It’s very fair to say we are going to have a less robust recovery than normal," said Tobias Levkovich, chief U.S. equity strategist at Citigroup.
But "that’s very different than saying we will have a very difficult recovery or no recovery."
Yet more bearish investors, and there are still many, see little reason for optimism. They say the economy will struggle for some time because of problems such as rising defaults on commercial mortgages and the large number of Americans who are unable to find full-time work, which reduces consumer spending.
At the same time, investors could also grow fearful of the huge bill America is accumulating to spend its way to recovery. The White House estimates government debt accounted for 90 percent of the economy’s total output in 2009, up from 70 percent a year earlier. Although the cost of borrowing for the government and others remains historically low today, it could surge higher in the coming years.
Meanwhile, banks and other financial institutions will face new waves of problems as more borrowers default on commercial mortgages and other loans in the coming year. At the end of September, delinquencies on commercial real estate loans held by banks climbed to 8.7 percent, their highest levels since 1993, according to the Federal Reserve.
Given all these challenges, skeptics worry that the breathtaking rally — the S&P 500 index has surged 66 percent since March — has made stocks too expensive. The 10-year price-to-earnings ratio of the S&P 500, a measure of how expensive stocks are relative to profits, was more than 20.3 in late December, up from 13.3 in March.
The average for the last 130 years is 16.4, according to calculations by Robert J. Shiller, the Yale economist.
Ritholtz said that just as investors were overly pessimistic in March, when stocks fell to their lowest level in more than a decade, they have become irrationally optimistic about the recovery.
"History tells us that this will end with a substantial correction," he said.
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