Rallying investors drunk on Fed cut

LONDON (CNNMoney.com) -- From the way stocks are trading, you'd almost think last month's upheaval in financial markets never happened.

The Dow Jones industrial average (Charts), a broad index that tracks 30 large U.S. stocks, is less than 200 points from its record closing high of 14,000 set in July. The broader S&P 500 index (Charts) is just shy of its highest level ever.

The stock rally got a jolt last week when the Federal Reserve decided to slash the target for a key short-term interest rate. By doing so, the central bank reassured investors worried that the economy would sputter because of the meltdown in the mortgage market.

Even as the economy shows signs that it will soften in the fourth quarter, analysts expect stocks to keep riding the Fed-inspired rally. But how much power does the Fed's action really have?

"Stocks have been rallying on the Fed's cut. But the multi-billion dollar question is how long investors will feel emboldened by the 50 basis point cut," said Paul Nolte, director of investments at Hinsdale Associates, a money management firm in Hinsdale, Ill.

The credit crisis that erupted last month sent equity investors fleeing for cover as panic spread across global markets. The worst of that storm looks to be over, and investors are piling back into stocks

The fear of recession, which had hounded investors, is quickly fading since the Fed has set up the expectation that it will continue to "goose things up," said Michael Darda, chief economist and director of research for New York-based MKM Partners.

The Fed's cut, along with plans by Congress and the White House to help homeowners hit by the subprime bullet, are also expected to help consumer spending, which accounts for two-thirds of U.S. economic activity.

With the American consumer in good shape ahead of the holiday shopping season, the outlook is looking upbeat for stocks, said Marc Pado, U.S. market strategist at Cantor Fitzgerald in New York.

"If you're going to have a negative view on the market, you have to have a negative view of the consumer - which I just don't see going into the fourth quarter," he said.

But even if stocks have room to fly higher, there are plenty of clouds on the horizon that could put the Fed in a tough spot and derail the rally.

Surging oil and gold prices, along with a falling dollar, have fanned inflation worries. A sustained rise in prices could limit the Fed's ability to keep cutting rates and could even force policymakers to raise rates.

In the long run, the U.S. economic slowdown could also start dragging on corporate profits, which at large companies have been propped up by strong international business.

But investors haven't been factoring in the possibility that slower growth will begin to wear on overall earnings, which have been growing at an "unsustainable" rate, according to Nolte, the money manager at Hinsdale Associates.

"It has been stuck in investors' heads that when the Fed cuts rates it's a good time to buy stocks," he said. "But we're not out of the woods yet."