I saw a post by Carol Platt Liebau arguing that the recent surge in the stock market corresponds with the increasing likelihood that his medical reforms will not pass, rather than a simple response to the end of major meddling in the financial sector. It is an interesting thesis, as far as it goes, but I think it overlooks a much bigger trend, one I have been rpedicting for some time. On the other hand, there is also a much less appealing possibility, and one that I have also mentioned many times, and we need to consider that as well.

Let us first look at the supposed "real" cause, the end of major bailouts for the financial institutions. This sounds great on paper, but does anyone bu it? Investors know that the institutions are as shaky as ever, just look at the charts for Citigroup. Not only did it not join in the general rise, it actually fell during the same period.  Likewise Bank of America and AIG both ended lower than they started over the past 10 days. Which definitely shows that investors think the financial sector si as weak as ever.

If that is the case, then do you think investors believe the bailout is over? If they expect future collapses among the financials, do you think they don't also expect government intervention? Having already spent a fortune averting collapses, the government cannot now stand back and allow those same firms to go under. So, if there is the potential for a collapse, it is certain there is also a strong likelihood of more bailouts, as circumstances make any other response impossible¹.

All of which means that the end of formal bailout makes little sense as the force driving the stock market.

Nor do I give any credence to those few who credit the stimulus package. The stimulus package would not help the stock market for two very good reasons. First, the majority of the money remains unspent, which means it is unlikely to have much impact on the larger economy. Second, even what has been spent has been spent almost entirely on government infrastructure projects which do little to drive firms listed on the NYSE or NASDAQ. Past experience has shown us that eventually growth in the local construction and building supply sectors, whether from government spending or new housing starts,  will trickle up to larger firms, but it takes quite a while, sometimes on the order of a year or more. There is simply no way the trifling amount we have spent so far, and mostly spent on local infrastructure, has had any impact on the major exchanges.

Nor is it an increase in confidence due to the stimulus. First, and foremost, because polls show that those who buy stocks (3/5 of which are held by the middle class) have little confidence in the stimulus actually stimulating the economy. If they don't think the stimulus will be beneficial, then they are not likely to buy stocks based on the expectation of the stimulus helping. Second, and more significantly, if the confidence in the stimulus were driving market increases, it would have come some time ago. There is nothing related to the stimulus which would make the past week special, no increase in spending, no release of new funds, nothing. So, given that the sudden increase came last week, it would seem the stimulus is an unlikely candidate.

No, the most likely positive cause (and I will talk about the much less pleasant alternative in a moment) is the sudden hesitation showed by the Obama administration on two fronts. Not only has Obama backed off somewhat on the medical reform front, as Ms. Liebau mentions, but even cap and trade has shown some hesitation.  With these two economy busting bills quietly shifted to the back burner, it makes sense the market would rally. After all, whether you think they are beneficial or not², no one can deny that the firms presently listed on the major indices³ would not fare well under either one.

Then again, the rally may indicate an even more significant event. As I have been arguing for some time, if the economy does not recover very soon, and recover very strongly, congressional Democrats, and maybe even some in the senate, may find themselves in an uncomfortable position, as supporting their president could cost them votes in 2010. As a result, it is likely that, starting in January, or maybe earlier, we will see the administration finding it harder and harder to pass any new major programs, be they spending bills or health care reform. It is why Obama has been pressing so hard for every initiative, declaring constant "crises", to ensure the bills pass before his congressional supermajority evaporates.

But it appears that some in congress have jumped the gun. Having decided they got all they could int he last budget, it appears they are trying to shore up their positions early, or else avoid providing any more ammunition to their future opponents, and have tried to ensure their names are not associated with any politically risky bills, such as cap and trade or health care reform.

More significantly, it appears investors have noticed. It is possible they are not only bidding up stocks on the basis of the two projects presently stalled in congress, but on the expectation that the same conditions will delay passage of any number of future bills which could prove harmful to the markets. Expecting much less spending, much less regulation, much less intervention, much less government in general, they have begun to buy at a higher price than they were willing to pay a few weeks ago.

And I wish I could end this article right there, leave everyone with a nice, optimistic outlook. But, unfortunately, there remains one other consideration.

As I wrote in "Overlooking the Obvious", there has been an infusion of new money into the financial system. Thanks to the massive deficits run up in his first few months, Obama has set the stage for a surge of inflationary price increases. As I wrote, the current economic slump has probably obscured the first indications of these, but, now that the capital markets are showing signs of life, it is possible that the first flush of inflationary overheating is beginning to show⁴.

It is impossible to tell which is the cause at the moment, whether we are seeing the healthy enthusiasm of investors freed of the expectation of future intervention or the sickly feverishness of a market feeling the distortions of an inflated money supply. The next few weeks and months will tell us for ure. If the markets grow steadily, but gently, then likely we are simply recovering from the earlier crash. On the other hand, if we see a series of massive surges, stocks rising in days to many times their previous values, IPOs being bid up to outrageous prices, all the absurdities we used to associate with the stock market during the dot-com bubble, then we are likely caught in the first stages of a new inflation.

In that case, the only question remaining is whether we will simply return to the overheated, inflationary markets we considered "normal" during the Clinton and Bush years, building our way to an even worse future crash, or whether the inflation will fail to dig us out⁵. If the latter, then we will either see price surges followed by almost immediate slumps, a series of miniature boom-bust cycles, with the larger economy entirely untouched. Or else we may see something even worse, an overall economy mirroring the excessive enthusiasm of the stock market, prices rising by double, even triple digit, increases. And, if that is the case, then we will get to experience first hand the hyperinflation we dodged by voting out Carter.

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1. If you doubt this, imagine the political fallout if, after all of TARP and the subsequent bailouts and stimulus packages, Bank of America or Citigroup were to fail? Every Republican on Earth would run on a platform of asking why we spent all that money only to end up where we started. Bailouts are inevitable so long as Obama is in office. It is unthinkable for him to do anything else.

2. I say "not". Just for the record.

3. I know some dictionaries have gone so far as to remove this plural form, and almost all (or all) have decided that "indexes" is acceptable, but as recently as the 1980's there were many dictionaries which insisted "indices" was the correct plural. And, to my mind, -ex forms do take -ices as a plural. The dumbing down of English, as a result of the dearth of classical education, is one trend which disturbs me more than all others. As Orwell argued, once you simplify the language, it is far easier to simplify the mind which uses that language, and bad arguments can more easily be passed off as profound.

4. I don't offer stock advice, but I do want to say that inflationary stimulation of the stock market does not mean one should get out immediately. When the market receives distorted signals, it often turns out well for the investor, though not for the  company or economy, as the company will misread profit and loss signals and pay out capital as dividends. I discussed this mechanism in "". Eventually the market recognizes this and collapses, as it did in 1929, and in the past few months, but for a time it is possible to do very well in a very sickly stock market, provided you get out in time. During inflation the stock market is sometimes a safer investment than banks or bonds, and, during some phases, pays better returns than even gold or land, though eventually investors will see huge losses if they don't leave the market for more concrete stores of value.

5. I know I predicted in "Overlooking the Obvious" that we had not been able to inflate our way out of our present crisis, but I may have spoken too soon. Looking at the market, it is possible the false "recovery" via inflation was just delayed, waiting for a trigger, such as the hesitations of the Obama administration. It will still mean nothing more than, at best, putting off our current crisis a few years, and making ti worse in the bargain, but it is possible we may yet inflate our way out of this crisis and into a worse one in the future.

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POSTSCRIPT

My writing on inflation in general is listed in the postscript to "Overlooking the Obvious". I wrote of the likely defection among Democrats in "Easy to Explain", "Confirmation", "Strange Bedfellows", "The Future", "And It Starts", "I Told You So!" and "Polls Both Confirm and Refute My Predicitons". I also wrote about the role fo falling popularity int he agenda of the Obama administration  in "Why Obama Won, And Why He Is Losing Support Now", "Falling Popularity and Vanishing Support", "Quick Note on Poll Results", "A Good Lesson", "Vindication" and "One More "Crisis"".

DISCLAIMER

Though I say it very briefly above, let me make this very clear. Nothing above should be construed as investing advice. my observations on the behavior of the market during an inflation are just that, observations. Then again, as my statement is that you can make money, but only if you manage the miracle of jumping out of the market at just the right time, then the conclusion you would get from my post is that it may be profitable to invest during inflation, but very risky. Still, I am offering no advice, and I am not liable if you somehow read my cautionary statements to mean "Go ahead, put all your money in Wal-Mart" and then lose your shirt.