Investing July 23, 2009, 9:00PM EST

The Stock Market's Fragile Rally

Investors are in a better mood lately, pushing stocks to new highs for the year. But the economy needs to show signs of strength for any turnaround to last

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The stock market is proving again that its movements don't always make sense. On July 23 the Dow Jones industrial average bounced back above 9,000 for the first time since January—on a day when Wall Street learned that more than 500,000 Americans filed for jobless claims last week.

Meanwhile, earnings reports show corporate profits falling by almost one-third, yet the stock market sits at its highest point this year. In the first two weeks of earnings season, in fact, the broad S&P 500 is up 11%.

That's not to say market observers can't cite explanations for the recent stock rally.

Second-quarter earnings are bad, but they're beating very low expectations. Before earnings season began, Thomson Reuters (TRI) said analysts were expecting second-quarter earnings for the S&P 500 to fall 35.6%. Now, updated based on early results, earnings should drop a mere 30.8%.

Companies such as 3M (MMM), which reported second-quarter results on July 23, are seeing profits and sales fall compared with last year. But they're beating first-quarter results, and they are raising estimates for profits in the second half of the year.

Americans continue to lose their jobs at an alarming rate. But the pace is slowing. Initial jobless claims have averaged 546,000 per week in July, but that's down from 612,000 in June, 630,000 in April, and 657,000 in March, Action Economics notes.

The Nasdaq Is Jumping

Still, there may be something other than fundamentals, such as earnings and the economy, that is driving the recent market rally. On July 23, the market's upward momentum was especially strong, with all three major indexes jumping more than 2%. The Dow broke through a psychological barrier of 9,000, closing at 9,069. The S&P 500 is now up 8.1% for 2009. Closing at 976.29, the S&P is tantalizingly close to its own round number of 1,000.

The Nasdaq composite index is up a whopping 25.1% this year, speaking to the relative popularity of tech stocks in 2009. The Nasdaq, at 1,973.60—just 1.3% from the 2,000 mark—has made up all of its losses since Oct. 2, 2008. The tech-heavy index—and the stock market as a whole—could be hurt by weak results from Microsoft (MSFT) and Amazon (AMZN) after the market close on July 23.

But bad news might not be enough to derail the rally entirely. That's because some of the key drivers of the market lately are psychological and technical, not fundamental. "Right now we are in a momentum-driven rally," says Prudential Financial (PRU) market strategist Quincy Krosby.

There is "panic buying," with many investors jumping into the market as it moves higher because they're afraid of being left behind, says Michael Church of Addison Capital Management.

Although the economy remains weak, Church wonders if the stock rally could become a self-fulfilling prophecy. Higher stock prices could revive the confidence of wealthy consumers, helping the economy get back on its feet. Those buying equities may be starting to include not just traders but pension funds and other institutions with major buying power. Compared with their usual allocations, institutional investors have been underexposed to equities all year, says John Merrill of Tanglewood Wealth Management. "You can only do that for so long."