The big stock rally: Not so fast

NEW YORK (CNNMoney.com) -- Ben Bernanke's testimony on Capitol Hill Wednesday was the latest sign to investors that the Federal Reserve's "Goldilocks" economy is here.

Stocks soared after the Fed chairman's remarks, sending the Dow industrials to a record high, along with the Dow transport and utility averages - the first time in nearly nine years that all three averages hit records on the same day.

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The broader S&P 500 index hit a 6-1/2 year high, the Nasdaq surged and Treasury bond investors, pleased by Bernanke's comments on inflation, sent long-term bond yields sinking.

From the euphoric reaction you might have thought Bernanke said something wildly upbeat and thoroughly unexpected. He didn't.

Overall, it was a market-friendly forecast, sure. But it's one that was pretty much laid out in the statement from the last Fed policy meeting in January - and it's a scenario that's been echoed by a number of recent economic reports.

And while the market may have celebrated Wednesday, some market pros say the outlook for the stock market this year is little changed, with the S&P 500 expected to rise just a bit less than 10 percent this year after jumping 13.6 percent last year.

"I don't think it changes anything," said Charles White, a portfolio manager at ThomasLloyd Global Asset Management.

"A few days ago we were hyperventilating that the sub-prime lending market was going to hit financial stocks," he said. "Then we had some comforting comments from the Fed chairman on a day when a number of people didn't make it into work because of the weather and so stocks rose."

In other words, make sure to take the fickle market with a grain of salt.

In his remarks to the Senate Banking Committee, which he repeated to a House panel Thursday, Bernanke "basically said the Fed thinks we're going to have a favorable combination of sustained economic growth and less inflation, with growth a tad below potential," said Stuart Hoffman, chief economist at PNC Financial Services.

"There wasn't much new there, but it does suggest a very harmonic combination and that was certainly music to investors' ears," Hoffman added.

As always, the Fed chief threw out the caveat that if the scenario proves to be wrong, the central bank will intervene and adjust rates accordingly.

The solid 3.5 percent pace of GDP growth in the fourth quarter of 2006 is expected to be revised down, Bernanke said, while GDP growth for 2007 is now expected to come in a bit slower than the Fed thought last summer, due to weakness in housing, he added.

Bernanke also said inflation pressures seem to be waning, adding that the Fed expects "core" inflation to ease back within the range of the Fed's presumed comfort zone by next year. (Read the testimony).

Following the comments, stocks and bonds surged, as investors bet that the economy is "in the sweet spot of not-too-hot, not-too-cold growth," said Rob Lutts, chief investment officer, Cabot Money Management, referring to what's come to be known as the Goldilocks scenario on Wall Street.

The remarks also apparently convinced investors that the Fed's next move will be to cut interest rates, which was a relief since some on Wall Street had grown worried about a possible rate hike. Investors like lower rates since they lower business costs and boost corporate profits - and stock prices.

"It looks like we're back to factoring in a 25-basis point ease by the end of the year," said Stephen Stanley, chief economist at RBS Greenwich Capital, noting that fed funds futures on the Chicago Board of Trade are now more decisively factoring in a quarter-point rate cut by the end of the year. There are 100 basis points in one percentage point.

After raising its key short-term rate target 17 times between 2004 and 2006, Fed policy-makers have held rates steady since August - waiting to see if their previous hikes would slow growth to a more sustainable pace and contain inflation.

Recent readings on the economy would suggest that the goal is being met. The central bankers' outlook has gotten extra help from a stronger-than-expected consumer - a result of a tight job market and a big drop in oil prices last month.

Even last year's rapid decline in the housing market has been a kind of a stealth help, said Stanley, since it means the market may be near the bottom and starting to head toward a long slow recovery.

Still, most economists say Wall Street hopes for a rate cut soon are probably overblown, with recent signs of economic strength meaning the Fed is probably on hold - maybe for the rest of 2007.

While stronger economic growth could bring stronger corporate profits, that could be tempered, oddly enough, by a decline in oil prices. Oil fell to below $49 a barrel in January on reduced supply concerns, before rebounding over the last few weeks.

But a note put out by research firm Sanford Bernstein Monday said that prices could drop as low as $30 a barrel this year, said ThomasLloyd Global's White. While that would help consumers this year, it could hurt corporate profits and the stock market over the next few quarters, White added.

Here's why.

With more than three-fourths of the S&P 500 having already reported December quarter results, earnings are currently on track to grow about 11 percent, according to the latest Thomson Financial estimates. While that's solid, it's still the slowest pace of growth in almost five years, and reflects the impact from declining energy profits.

Energy profits have fallen due to tough comparisons after several strong years, but also in response to lower oil prices. If oil prices do keep declining - whether or not at the pace Bernstein suggests - profits for the influential energy sector will decline even more so throughout the year. And so will overall earnings, contracting price to earnings ratios and making stocks more expensive.

Yet another reason why stock returns are likely to be moderate this year, now matter what Ben Bernanke says about the economy.

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