Why This Stock Rally Can’t Be Trusted

This may be one of those rare moments when market strength is a signal of growing danger, rather than a sign of better times to come.

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At a time when European economies are fast deteriorating, the U.S. stock market has been surprisingly buoyant. Since October, the Dow has climbed 19%, adding 400 points in just the past week. Yet although the U.S. economy has improved a little, the global picture is looking a whole lot worse. Do investors really think America can go it alone, or is there another explanation for the current market rally?

In fact, we may now be witnessing one of those rare moments when market strength is a signal of growing danger, rather than a sign of better times to come. Here’s how that can happen: It’s true that the U.S. economy has picked up a little. And it’s true that unemployment fell in the second half of last year from 9.1% to 8.5%. But growth is still too slow to keep bringing unemployment down. So to understand what’s propelling stock prices you have to look across the Atlantic to Europe, where the situation is pretty scary. Consider just these three recent developments:

Widespread credit downgrades. Standard & Poor’s has lowered the credit ratings of nine European countries, including France, as well as that of the bailout fund that is supposed to rescue the most financially troubled countries.

Worsening problems in Portugal. A deteriorating economic outlook in that country has led buyers of Portuguese bonds to demand sky-high yields. Last week, the interest rate on 10-year issues reached almost 15%. At that level, Portugal appears headed for a default. That means Europe is now looking at a second imminent bailout, in addition to Greece.

(MORE: What Last Year’s Stock Market Says About 2012)

An impasse in Greece. Policymakers don’t have very much time left to prevent a Greek default. Moreover, talks appeared to stall over the weekend as major creditors left Athens without the deal they needed for the meeting of European finance ministers on Monday.

How does this all add up to a robust U.S. stock market? The European Central Bank has been buying massive amounts of bonds in an attempt to prevent interest rates from rising in Europe’s most indebted countries. That has added to the pool of hot money that is now fleeing the weakest European countries and heading for safe havens. Germany, the Netherlands, Switzerland and Austria just aren’t big enough to absorb it all, so much of that hot money is pouring into the U.S. That, in turn, is creating a bubble in Treasury bonds and a possibly unsupported stock market rally.

Hot money flows typically don’t last a very long time, so the U.S. stock rally could run out of gas with little warning. And if a European country does default on its bonds, creating a global banking crisis, U.S. shares could take a sizable hit – at least temporarily. Maybe U.S. stocks do deserve to trade at higher prices sometime in the future, but there’s still good reason for caution in the short term.

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