With the Dow Jones Industrial Average up 24% from its March low, both bulls and bears are feeling they will soon be vindicated.

The bulls are finding more evidence that this rally is the start of something lasting. The bears warn that the higher the market goes, the more pain will be suffered on the other side.

Strangely, both are pointing to the same part of the economy to make their opposing cases: the lending system.

“The epicenter of the fear is the idea that banks are full of toxic assets,” says James Paulsen, chief investment strategist at Wells Capital Management, which oversees about $375 billion as Wells Fargo’s money-management arm. He thinks the mortgage-backed securities held by banks are worth much more than people think, and that “we could have a V-shaped recovery” in the economy, and the stock market, as confidence in the lending system returns.

George Feiger thinks that idea is crazy.

“The core of the problem is the credit system and the credit system is severely damaged,” says Mr. Feiger, who oversees $1.3 billion as chief executive of Contango Capital Advisors, a subsidiary of Zions Bancorp. “Unwinding the credit bubble is going to take years, not quarters. We see this stock rally as an opportunity to sell.”

How can smart, experienced investors disagree so strongly, when looking at similar data? Let’s hear from the optimists first.

Mr. Paulsen of Wells Capital expects consumers to begin borrowing more heavily against their homes, and sees economic growth recovering amid a pickup in consumer spending and exports. Even if growth doesn’t return to where it was, he says, the improvement should be enough to pull stocks up from their heavily depressed levels.

He and others point out that even during the troubled 1930s and 1970s, stocks enjoyed strong, albeit temporary, bull markets. The Dow almost doubled from July 9, 1932, through Sept. 7, 1932, and then did it again in the first half of 1933, even as the banking system continued to crumble. Stocks fell again later, but not back to 1932 levels. Historically, the Dow often has rebounded sharply after being down around 50%, as it was this time.

In the optimists’ view, the credit system, juiced by well over $1 trillion in government aid, is slowly repairing itself.

Demand for mortgage refinancing has blossomed as mortgage rates have fallen. Investors are snapping up risky credit instruments such as junk bonds. Last week saw the busiest day for junk-bond sales in more than six months as hospital operator HCA and phone-tower operator Crown Castle International sold debt.

Late last year, yields on corporate bonds were pushed skyward, adding to the difficulty of issuing new bonds. Since late November, however, even junk-bond yields have been falling, a good sign for corporate borrowers. The difference, or spread, between junk-bond yields and Treasury-bond yields has tumbled, according to Merrill Lynch indexes, although it still is almost twice what it was just a year ago.

The optimists point out that banks including J.P. Morgan Chase, Goldman Sachs Group and Citigroup reported better-than-expected first-quarter profits. Banks are able to issue bonds cheaply with government backing, helping increase their lending margins.

It is signs like these that analysts like Michael Darda have been waiting for. Mr. Darda, chief economist at Greenwich, Conn., brokerage firm MKM Partners, was skeptical of the stock outlook as recently as late last year, but not any longer.

“We continue to believe the expansion will build steam into 2010 as an easy Fed policy collides with the spend-out from the fiscal stimulus,” Mr. Darda said in a report. He expects this trend to continue, with the recession ending between June and October. He notes that it is normal for the stock market to recover just ahead of the economy, which makes him bullish now.

The pessimists are turning to similar data to make the opposite case. Bears note that bank profits are due in part to government support, which has reduced the need for write-offs. Some of the new bank lending lately, they add, is because stressed borrowers are being forced to tap their credit lines. And big banks like Citigroup and Bank of America are still relying on government guarantees to sell bonds, a sign that credit markets remain fractured.

“Some people say the economic conditions are starting to bottom here. I would be really surprised if that happens,” says Steve Lehman, who helps oversee a $1.8 billion mutual fund at Federated Investors in Pittsburgh. “The banks are technically insolvent. They have become basically Enron-like hedge funds.”

He worries that the proliferation of home foreclosures, debt write-downs, severely underfunded pension plans and credit-card losses is far from over, which could hobble economic growth and stock recovery.

At some point, Mr. Lehman says, stocks are likely to fall enough that the ratio of stock prices to corporate earnings for broad stock indexes will drop into single digits, from about 13 now, and stay there a while. That happened during major bear markets in the past but hasn’t yet happened this time.

Such a decline could push the Standard & Poor’s 500-stock index below 600 before the selling ends, he says, although stocks could go through plenty of ups and downs before that happens. The S&P 500 finished Friday at 869.60. Its lowest close for the current bear market was its 12-year low on March 9 of 676.53.

“Many of the people I deal with every day want to go back to the good old days,” adds Mr. Feiger of Contango. “I feel I am surrounded by people who are desperate for the party to start again. I don’t see that happening.” He, too, believes the damage is deeper than the optimists realize.

He is particularly concerned about what economists call the “shadow banking system.” That is the system under which banks sold off loans to investors, including other banks. Those sales permitted a vast expansion of credit, but they also tempted banks to be less careful in their lending. And because they then bought back many such loans in the form of asset-backed securities, the banks ironically were among those left holding the bag.

Now investors won’t buy such securities and the shadow banking system has been left for dead. Mr. Feiger estimates that, before the bust, 60% of all loans were held outside the normal banking system. Who, he asks, is going to step up and extend that kind of credit in the future?

Optimistic money managers point out that even if the overall stock pullback isn’t over, the Dow industrials enjoyed five surges of 20% or more from September 1929 until they finally hit bottom in July 1932. The bulls want to get in on such rebounds, and add that it won’t take 2½ years this time for the market finally to hit bottom.

The bears counter that it is still too risky to try to time the market’s violent ups and downs. They feel safer keeping exceptionally large amounts of cash in money-market funds and Treasury bonds.

Whether they wind up changing their minds, and shifting some of that hoard to stocks, could determine how much longer the recent rally continues.