Gene Walden: After 10,000, what next for stocks?

Now that the Dow Jones industrial average has rallied back to the 10,000 level, what's next?

That all depends on the economy. If it strengthens, the stock price gains should hold up or even rise. But if the economy suffers a relapse, stocks will likely follow.

"We're encouraged by a lot of the things that have contributed to the rebound in the market," said David Koch, director of equity investing for Minneapolis-based Windsor Financial Group. "We've seen normalization of the credit spreads between corporate bonds and Treasuries, we've seen some stabilization of the housing market, albeit fragile, and the word 'depression' has been taken out of the equation. The 'Great Recession' is over."

But while the economy appears to be healing, it is a long way from full recovery. Unemployment is still near 10 percent and most sectors of the economy remain weak.

"Spending on everything from machine tools to housing is at a historically low point -- probably the lowest since the 1940s," says Koch. "Excess capacity is prevalent in nearly all areas of the economy."

Without the federal stimulus boost, the economy might still be on shaky ground. "The government has been the lifeline of the economy and continues to be a primary provider of liquidity for the markets," adds Koch.

Since the recession began in the fourth quarter of 2007, GDP has been negative every quarter through June 30. Most economists expect the third quarter ended Sept. 30 to be positive.

While the economy is showing some positive signs, many sectors remain weak. "Many regional banks are still saddled with commercial loans," said Koch. "Banks are still reluctant to lend money and take on risk."

The high price the government is paying to subsidize the financial system could have long-term repercussions for the economy and the markets. "The federal debt is predicted to double in the next 10 years," Koch said. "Couple that with potentially higher taxes and more government regulation, and that could lead to slower growth coming out of this recession than we've seen in the past."

One positive factor for the markets is that investors have been hoarding billions of dollars, stashing their money in safe investments such as savings accounts, CDs, Treasury bonds and money market accounts. Once the economy finally stabilizes, that money could flow back into the stock and corporate bond markets, helping to further prop up returns.

But in the meantime, Koch suggests investors maintain a lower exposure to economically sensitive stocks, opting instead for defensive-oriented stocks, such as consumer staples, health care and energy.

Safer stocks?

Now that many stocks have rebounded with gains of 50 to 100 percent over the past seven months, what sectors represent the safest areas for stocks in the current economic environment?

"Although corporate earnings have been beating expectations, companies have done so, by and large, through massive job cuts and other cost-cutting measures," Koch said. He recommends that investors stick with quality blue-chip stocks and companies with significant foreign exposure because he expects the dollar to weaken as the national debt grows, making U.S. goods cheaper overseas.

He also recommends finding companies that have managed to continue to increase their dividend year after year. "Historically, more than 40 percent of total return in the stock market has come from dividends," says Koch. "Right now, 15 to 20 percent of the Standard & Poor's 500 stocks have yields higher than U.S. Treasury yields."

There are several dividend-paying stocks that look promising to Koch right now. "Chevron and ConocoPhillips are both paying yields of about 4 percent. General Mills and Nestle are paying dividends of around 3 percent, and some of the leading health care companies, such as Johnson & Johnson, Abbott Labs, and Novartis, are paying dividends of around 3 percent or more," he said.

He also likes Vodafone, which is paying about a 5.5 percent yield, as well as Xcel Energy and CenterPoint Energy, both paying yields of 5 to 6 percent.

Koch said he believes companies with significant foreign operations, such as Ecolab and Emerson Electric, would also be good defensive stocks.

The market rebound since March has helped restore a great deal of wealth to a wilted economy. But going forward, the best bets may become harder to come by.