Issue of the week: Which way for the stock market?

I hate to spoil the party, said Shawn Tully in Fortune, but stock prices have nowhere to go but down. That might sound unduly pessimistic when the Dow Jones industrial average has risen comfortably above 11,000; prospects are good for “a new, business-friendly Congress”; and the best of the economic recovery is yet to come. But “the basic math doesn’t support the optimists’ case” for stocks. The problem is that corporate profits are unsustainably high. They’ve soared because in 2008 corporations cut staff to the bone and hunkered down for a “cataclysm” that never arrived. Two years later, “corporations are still operating with ultra-lean workforces, leading to a big jump in productivity” and “an amazing surge in profits.” Stock prices would keep moving higher if those profits continued to rise, but history suggests that “when earnings are already at lofty levels, they typically stagnate or fall rather than grow.” And so, unfortunately, will stock prices.

It won’t be a gentle decline, said Keith McCullough in CNNmoney.com. “An almost perfect storm of economic and political warning signs” point toward a single, terrifying conclusion: “The stock market is due for a crash.” The drop is likely to last one to three trading days and take the market down anywhere from 5 percent to 7 percent. Among the warning signs is the 10 percent surge in the Standard & Poor’s 500-stock index since late August, which has occurred in the absence of data suggesting a strengthening economy. To the contrary, the economy is weakening, judging from the drop in the Consumer Confidence Index to 48.5 in September from 52.3 in August. A fast-inflating real estate bubble in China is adding to the anxiety, said Jack Hough in SmartMoney.com. Land prices in China are up 800 percent since 2003. That market is ripe for a fall, and when it arrives, China will have a lot less money to invest in our Treasury bonds or to buy things from U.S. companies like Caterpillar.

Don’t panic, said John Prestbo in Marketwatch.com. “The historical breezes seem to be blowing in the right direction for the remainder of the year.” Start with the Dow Jones industrials, which fell 4 percent from January through August. Paradoxically, that’s a hopeful sign. Since 1896, there have been 12 occasions when the Dow fell that far in the year’s first eight months. In eight of those 12 years, the Dow subsequently rose an average of 7.3 percent in the final four months. It’s also a historical fact that the Dow almost always rises in the final three months of any year. Of course, 2010 could be different, but if past is prologue, investors’ worst fears won’t be realized this year.

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