How long can the rally last?

Market watchers predict a pullback as stocks fall back in line. But after that, the bulls may be back in town.

By Scott Cendrowski, reporter

NEW YORK (Fortune) -- The Dow Jones industrials stormed past the 9,000 mark Thursday for the first time since January, as traders delighted in surprising corporate profits and a rise in housing sales. But are the markets getting ahead of themselves?

Many analysts say they're not -- at least by too much

Since their lows on March 9, the Dow (INDU) has climbed 37% while the S&P 500 (SPX) has gained 43%. Strategists say losses may come in the next two months as stocks fall back to normal valuations. The average stock in the S&P 500 trades at 17 times earnings compared to 13.5 just three months ago.

"The Dow has come very far and very fast," says Hugh Johnson, chief investment officer of Johnson Illington Advisors, who oversees more than $1.5 billion in assets. "On a short-term basis it is somewhat overvalued."

Johnson says the Dow could decline 5% to 10% before year's end to fall in line with historical valuations and market history. Even so, he predicts the U.S. is in the fourth month of a cyclical bull market. According to Johnson's analysis, cyclical bull markets since 1890 have had an average duration of 38 months and sent their stock up by 130%.

"If you look at the history of the bull market -- both in duration and magnitude -- this one is the early stages," he says. "This one has longer and further to go."

Others market watchers agree. Deutsche Bank chief U.S. equities strategist Binky Chadha says gains in the Dow and S&P 500 are sustainable with the rise in the greater economy.

"There's no doubt that the earnings we've seen for far have come in better than expected," says Chadha, who notes that 75% of the S&P 500 companies already reporting earnings have beaten analysts' expectations. That's notably higher than the historical average over the last 10 years of 62%.

Chadha notes that stocks are trading above historical levels on a price-to-earnings basis. The S&P 500 index has traded at 17 times earnings for the past four quarters, compared with the historical average of 15. Yet he believes the economy will continue to improve gradually, noting that 8 of the 11 economic indicators in a Deutsche Bank index have been positive since July 10. "I think that there's upside on the equity markets on a whole," Chadha says.

And J.P. Morgan Funds chief market strategist David Kelly expects the Dow to stay above 9,000 as the economy shows increasing signs of recovery.

"I think the most likely scenario is the market has a very good second half of the year and it builds in these gains," says Kelly. "There's nothing dramatic going on in the economy, but the economy is doing what it's supposed to do."

"There's a gathering body of evidence that the economy is on the road to recovery," he says. "It could be a long bull market if the economy can get to positive economic growth and stay there for a few years." To top of page

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