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Economic Clouds? Wall Street Sees Signs of Sunshine

Main Street may be struggling, but Wall Street is on a bit of a roll.

Despite a drumbeat of bad economic news, the stock market is up — almost 11 percent in the last few weeks. Junk bonds, those risky corporate I.O.U.’s, are rallying. The value of financial shares, bank loans, tricky credit derivatives — up, up, up.

Many on Wall Street, the epicenter of the credit mess, seem to think that the worst is over. For the first time in months, analysts and executives sound upbeat again. Many of them see a broad, sustained recovery in both the economy and the financial markets coming in the second half of this year, a prediction some market strategists call hopeful at best.

For now, policy makers are echoing the mood on Wall Street. Treasury Secretary Henry M. Paulson Jr. said in an interview with Bloomberg Television on Thursday that “we are closer to the end of this problem than we are to the beginning.”

Photo: Oliver P. Quillia for CNBC.com

A report from the Bank of England, meantime, concluded that mortgage securities, which have been at the heart of the financial troubles, probably have fallen too far. The central bank said prices of such securities should “improve gradually in the coming months.”

Financial stocks and the broader market surged on Thursday as the dollar strengthened and oil prices fell for the third day in a row. The Standard & Poor’s 500-stock index closed up 1.7 percent, to 1,409.34 points; the Dow Jones industrial average notched a 189.87-point gain, to 13,010; and the Nasdaq composite jumped 2.8 percent. Another day or two like that, and those market benchmarks will be in the black for the year.

It is a remarkable reversal in attitudes from just a few months ago, when the broader economy seemed relatively healthy but Wall Street was traumatized by billions of dollars in mortgage-related losses. Now, bankers and investors appear ready to look past the crisis to more profitable times, while consumers find themselves in a more precarious position as the job market weakens and banks make it harder to borrow money.

It is, of course, not uncommon for Wall Street to run ahead of the broader economy. Investors, after all, make money by anticipating the future. The job market, by contrast, improves more slowly than other aspects of the economy.

But specialists say the two sides will eventually converge. Either the markets will give up their recent gains or, if the optimists are right, the broader economy will show greater strength as tax rebate checks and lower interest rates stimulate the economy.

There have been false dawns before. Last spring, after several mortgage companies collapsed, Mr. Paulson and the chairman of the Federal Reserve, Ben S. Bernanke, said the problems appeared to be “contained.” In early October, just two months after credit markets froze up, the stock market climbed to an all-time high.

The optimists believe it is different this time. The catalyst for the change, they say, was the Fed-arranged deal that sold a troubled investment bank, Bear Stearns , to JPMorgan Chase in mid-March. The central bank further restored order in the markets by lending directly to investment banks, assuring that big securities firms could not be undone by a crisis of confidence.

In the last month, the cost of insuring against the failure of banks and other companies has fallen sharply. Pressures on financial firms also appear to have eased somewhat because banks have tended to borrow less from the Fed in recent weeks than they did in March and early April. The cost of interbank borrowing has also fallen.

“There has been a huge change of sentiment in all of the markets, a lot of the fear has been gone,” said William Knapp, investment strategist for MainStay Investments, a division of New York Life.

Still, skeptics say the optimism on Wall Street is premature. These people argue that even if the Fed has defused the immediate liquidity crisis facing the financial system, much pain lies ahead in the housing market and the broader economy.

“We should be very grateful that things appear to have improved in the financial sector and that significantly reduces the risk of a financial meltdown,” said Bernard Connolly, chief global strategist for Banque AIG in London. “But it doesn’t mean that there is not going to be a deeper and more protracted U.S. slowdown than people had thought.”

Foreclosures are climbing at a strong clip and the decline in home prices has picked up speed in recent months. Rod Dubitsky, an analyst at Credit Suisse, estimates that falling home prices, tighter lending standards and job losses could force an additional 2.8 million mortgages into foreclosure in 2008 and 2009. That would be on top of the 1.2 million loans that were in foreclosure in January.

One sign that the mortgage market remains unsettled is that the national average for a 30-year fixed mortgage has climbed modestly, to 6.06 percent on Thursday, up from 5.85 percent at the end of March, according to Freddie Mac, the government-sponsored mortgage lender.

Analysts expect uptick in profits for the second half of the year

The job market is also weakening. The unemployment rate, which measures the number of people without jobs who are actively looking for work, remains low at 5.1 percent, but the percentage of working-age Americans without a job has risen significantly in recent months. The Labor Department will release the employment report for April on Friday, and a big reduction in jobs and increase in unemployment could put a damper on Wall Street’s enthusiasm.

In addition to the employment picture, the market closely follows corporate earnings. Profits have fallen every quarter since the third quarter of last year, largely as a result of write-offs at financial firms and losses at homebuilders and other firms that rely on discretionary consumer spending.

“The nonfinancial sectors are doing pretty well,” said Robert C. Doll, vice chairman at BlackRock, the investment firm. He added: “I am not making the case that the consumer and the economy is not weak, but I think it’s a lot stronger than the bears are saying.”

Analysts expect a sharp upturn in profits in the second half, in part because the earnings will be compared with weak results from 2007 but also because exports are surging. The $117 billion in federal tax rebates that will start going out this month should also help bolster profits.

But some specialists say that the market’s expectations for profits are too lofty. They assert that slowing consumer spending will offset the gains corporate America is reaping from rising exports, which may also suffer because economies in Europe and Asia are starting to slacken.

Analysts have been lowering their profit forecasts in recent weeks. At the start of April, for instance, second-quarter profits were expected to fall 2 percent; now analysts are estimating earnings will fall 6 percent, according to Thomson Reuters.

“I don’t think it’s a definite by any stretch of the imagination that we are in for a recovery in the second half,” said K. Daniel Libby, a senior portfolio manager at Sands Brothers Select Access Management Fund. “There are still plenty of downside risks to the economy.”

Some specialists say the market is bouncing between despondency and exuberance, as it often does when the future is cloudy. The S.& P. index fell about 10 percent in the first three months of the year, its worst quarterly performance in more than five years. In April, however, the market jumped 4.8 percent, its best month in four years.

“Sentiment had gotten so pessimistic that it was the perfect opportunity for the rally that we have had,” said Liz Ann Sonders, chief investment strategist for Charles Schwab. “Now, you have seen a pretty quick reversal. That’s natural for the market.” Ms. Sonders added, “I think in general, we ought to hold off on either extreme.”

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