Dow breaks previous record set in October 2007 as investors absorb signs of recovery in US and better figures in Europe

The Dow Jones Industrial Average on Tuesday surged to its highest closing level ever, erasing the index's loses during the financial crisis even as Washington fights over its debts and Main Street seems far from mended.

The Dow closed at 14,254, passing its previous high of 14,164.52 in

October 2007.

Better-than-expected news from the service sector bolstered the rally that had begun even before the market opened. Dow futures, a somewhat unreliable indication of the direction the market is likely to take, pushed the index higher before the opening bell as investors absorbed better-than-expected retail figures from Europe.

On Monday, the Dow closed at 14,127.82, up 38.16 points, or 0.27%, a 52-week high. The index has risen for four of the past five trading days.

The Dow has not touched these levels since before Barack Obama's first election victory. Global stock markets went into freefall shortly after, as the implosion of housing market and Europe's woes dragged the world into the worst financial crisis in living memory.

Dow Jones chart Photograph: Graphic

Massive issues remain, however. Unemployment, especially among the young, remains high, and in Washington politicians are still at loggerhead over America's $16tn debt. Last Friday the government started making $85bn of cuts – known as the sequester – in a move Obama and others predicted would cause widespread chaos and financial hardship. In Europe, major US companies including GM and Ford are being hit by the region's continuing economic crisis.

But these are old debates now – and Wall Street doesn't seem to be worried.

The latest figures from the Institute of Supply Management (ISM), released Tuesday morning, showed positive growth in the service sector. The ISM index stood at 56 in February. Anything above 50 indicates growth, and the number was ahead of analysts' forecasts. US markets were also buoyed by rallies in Europe and Asia. In London the FTSE closed up 86.32 points.

The Dow Jones index has now more than doubled since a low point in March 2009, stunning many market watchers and coming against a still lacklustre economic recovery. Corporate profits hit record highs last year, fuelled largely by cost cuts. Economists and market watchers said the Federal Reserve's massive bond-buying programme has fueled the market but that beneath that there were concrete signs of improvement.

Gus Faucher, a senior economist for PNC Financial Services Group, said Washington still mattered and warned that if the sequester drags on, the Dow's gains could be at risk. "That said, the fundamentals are better. Profits are at an all-time high, business balance sheets have improved, interest rates are low. The markets are expecting more growth through 2013."

Jack Ablin, chief investment officer at BMO Bank, said investors fed up with low yields from the bond markets were looking for better returns in equities. Bonds were also being issued in order to buy shares, he said. He said the wider economy looked like it was steadily improving, but warned there could be problems ahead.

"Investors are embracing progress. They weren't shaken by the tax hikes at the end of the year and not by the sequester either," he said. "The Dow looks fairly priced now."

But he warned that the Federal Reserve's massive bond-buying policy could drive more people into equities. "If you want to see a swift end to monetary easing, another 10-20% hike in the Dow will probably do that," he said.

Minutes of the Fed's last meeting revealed a split in the central bank's rate setting committee. While the Federal Open Markets Committee's members were still worried about unemployment, "many participants also expressed some concerns about potential costs and risks arising from further asset purchases", according to the minutes.

Friday may prove the next test for the markets, and the Fed, when the latest nonfarm payroll figures are released. The US added 157,000 new jobs in January. Average job creation for 2012 was around 181,000, a number just above the benchmark economists calculate is enough for the unemployment rate to stabilise, but not fall.