Here comes Dow 10,000. Again

The Dow is approaching the five-digit level for the first time since October. Is that evidence of an economic recovery or a sign the rally's running out of steam?

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By Paul R. La Monica, CNNMoney.com editor at large

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How has the Federal Reserve handled the economic crisis?
  • Well
  • Has had little impact
  • Poorly

NEW YORK (CNNMoney.com) -- The FDIC deposit fund is running out of money. The dollar continues to look like a 97-pound weakling against the euro and gold is above $1,000 an ounce.

But none of that matters to Wall Street. This is turning into the Bob Marley "Three Little Birds" rally."Don't worry about a thing, 'Cause every little thing gonna be all right."

The Dow, barring a major setback in the markets over the next few weeks, is poised to soon cross above 10,000 again. When it does, that will be the first time it has cracked through 10K barrier since last October. And that will probably spark another wave of questions about whether the rally has come to far too fast.

So has it? It's becoming more difficult to do what traders call fighting the tape. Momentum is clearly on the bull's side and it's hard to figure out just what could derail stocks in a meaningful way in the next few months.

If there is anything that could throw a dent in the rally, it probably would be tepid earnings. The third quarter ends next week and most major companies will release their results in mid-October. Investors will need to keep a close eye on these reports for signs from Corporate America that the recovery is for real.

Michael Cuggino, president of Pacific Heights Asset Management, a San Francisco-based investment firm, said he thinks third-quarter earnings for many companies will actually be relatively strong. He said that results will still largely be driven by reductions to expenses as companies slash payrolls and budgets.

But he added that the improved outlook for the global economy could also lead companies to give investors more upbeat guidance for the critical fourth quarter.

In the past few weeks, companies ranging from cruise line operator Carnival (CCL) and food company ConAgra (CAG, Fortune 500) to shipping giant FedEx (FDX, Fortune 500) have raised their earnings targets. And some companies, such as semiconductor manufacturers Texas Instruments (TXN, Fortune 500) and Intel (INTC, Fortune 500), have even boosted their sales forecasts.

"A more favorable economic backdrop should mean more favorable earnings," Cuggino said. "Cost cutting is playing a role, but there are diminishing returns there and companies need to show top-line growth. But that's what is most encouraging: there are signs that revenue will improve in several sectors."

It goes without saying that the better the earnings news is, the better that is for the markets. Keep in mind that many analysts are still wary of being too optimistic, for fear of seeming too Pollyannaish.

As a result, estimates for the third and fourth quarters, as well as 2010, may now be too low. If that's the case, stocks could continue to climb higher in the near term because stocks may not yet be factoring in the possibility of better-than-expected profits next year.

Edwin Lugo, manager of the Franklin International Small Cap Growth fund, said he thinks that the stocks he looks to own in his fund are no longer trading at distressed levels but they haven't run up so dramatically that he would now consider them fully priced.

So as long as honest-to-God improvement in sales and earnings, and not just hope and hype, are driving stocks higher, that could mean the rally can sustain itself without a major pullback.

"You are beginning to see instances where companies are talking about volume growth coming back and pricing power coming back," Lugo said. "So you can probably anticipate that, on the valuation side, some stocks will still look attractive."

Of course, that doesn't mean that investors should be blissfully ignorant of some of the significant concerns I've mentioned -- not to mention some others.

There are fears that a big chunk of commercial real estate loans on the books of major banks may soon spoil like milk after its expiration date. And until the job market improves, banks could also find themselves getting hit by bad credit card loans.

That means investors should pay particularly close attention to how banks do in the third quarter and what they say about the fourth quarter. It's tempting to think that the worst may be over for banks now that many of them are rushing to pay back bailout funds.

Doug Ober, chairman and CEO of Adams Express (ADX), a closed-end fund that invests mainly in U.S. stocks, conceded that "the clouds are beginning to lift" for financials. But he said his fund is still light on bank stocks because the challenge is going to be finding companies "that are not going to get destroyed by credit cards and commercial real estate."

If the banks disappoint, that could deal a huge psychological blow to the market. The banks led us into this mess last fall and they have led the rally since March. So whatever direction the banks move in over the next month or so is likely to dictate what the broader market does.

Talkback: How much higher can the Dow and overall stock market go? Are you buying the rally or do you think the bear is lurking just around the corner? Share your comments below. To top of page

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