How High Can We Go?

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OK, so the market's in a rally. A big one. How much longer will it continue, and how high will it go? Not even the pros on the “Cost of Freedom” can answer that, but it's pretty easy to look at what's causing the rally, and the best and safest way to play it.

While no one can say why the market does what it does, investors can thank a happy combination of factors: oil prices have fallen more than 20 percent since July. Corporate profits are robust. The Federal Reserve has paused, and possibly ended, its 17-quarter, point-interest-hiking campaign. Breaking the psychologically-significant ceiling of 12,000 only further greased the wheel.

So what should investors do? Tread carefully. Including the current sharp rally, the Dow has now gone over 900 trading days without a 10 percent correction. That puts this rally in the top five longest uncorrected advances on record, and a look at some interesting research recently put out by Hussman Funds, examining what happened after prior runs, doesn't bode particularly well. The last time the market went this long without a correction was in 1997, after 1,723 trading days, and it lost 10.6 percent of its value before registering the next 10 percent advance. In 1946, the market sustained a run of 1,020 days and dropped 23 percent before any significant gains.

Numbers aside, there are reasons investors should exercise caution. Stocks are expensive right now, with the Dow trading at roughly 18 times earnings (before the 1997 correction, its high was 23.7; at the height of the 1946 rally, it was 16.2). Economic growth is slowing, and economists who have long talked of a soft landing are growing increasingly concerned about a not-so-soft one. The housing sector and auto sector have each seen sharp declines. October tends to be a historically volatile month, and the uncertainty-fearing market is known for getting a little jittery around November elections.

To be sure, hitting 12,000 was a morale-booster and a big hurdle, both psychologically and historically, and we may well see this rally extend into the fourth quarter. But the trends in the markets that may unfold a little more slowly are more important: inflation, economic growth, and the global geopolitical climate.

Leigh Gallagher is a senior writer for SmartMoney magazine and a regular contributor to "Cavuto on Business."