The Economy Improves, the Stock Market Doesn't

US News

Does the stock market know something the rest of us don't?

The economic news has been upbeat recently, yet stocks have been treading water for the last week or so. First, the good news. Economists were worried that the tax hikes that went into effect at the start of the year--especially the two-percentage-point increase in the payroll tax, which affects nearly everybody--would cut sharply into consumer spending. It now appears that didn't happen, not yet anyway.

Retail sales in January were at nearly the same levels as in 2012, on average, with no big decline caused by higher taxes. Consumer confidence, which slumped early in the year, now seems to be rebounding, with Americans growing more optimistic about the future. Economists figure that a housing rebound, a rising stock market earlier this year and the restoration of household wealth is making consumers feel better, regardless of what goes on in Washington.

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The stock market, however, has been moving in something of a contrarian direction. It rose by a healthy six percent or so during the first five weeks of the year, which is the same period of time when consumer confidence was falling and fears of a big consumer pullback were mounting. That surprising rally convinced some analysts that the "great rotation"--a massive move by investors out of relatively safe bonds into riskier stocks--was finally happening.

The market has stalled over the last week, however, even as economic news suggests the economy is faring better than expected. "Investors appear to have become desensitized to positive economic data," Carlos Guillen of investing firm Wall Street Strategies wrote in a research note.

The stock market, of course, doesn't always respond in direct correlation to economic news. Sometimes it actually does the opposite. Stocks tend to rise when bad economic headlines increase the odds that the Federal Reserve or some other policymaking body will intervene to aid the economy. So investors may reason that an improving economy could bring an earlier end to Fed policies, such as quantitative easing, than expected.

[READ: 20 Industries With Record Numbers of Jobs]

There have, in fact, been recent signs that some Fed officials are growing increasingly "hawkish," which means they may favor interest rate hikes and other tightening measures, which could push stocks down, sooner than the Fed has previously indicated. Still, the Fed has set trigger points for policy changes--such as the unemployment rate falling to around 6.5 percent--that aren't on the near horizon yet. So worries about Fed tightening may be premature.

Psychology is another factor that may be holding back investors. The Dow Jones Industrial Average has been in a holding pattern just short of 14,000, a number that has no technical significance at all but would represent a kind of psychological breakthrough if stocks rose above it and stayed there. Investors may not believe in their guts that the economy is really strong enough for the Dow to approach and exceed its all-time high of 14,165, which it hit on October 9, 2007.

Washington is still generating plenty to worry about, too. The next fiscal bump is the "sequester," a set of spending cuts totaling about $110 billion per year for the next decade, which is supposed to kick in March 1. If it happens, it would slice about 0.7 percentage points off GDP growth.

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There's growing evidence that consumers and investors are developing a sort of immunity to the antics in Washington, with the stock market and other indicators showing less volatility than they used to when Washington politicians dither over big decisions that directly affect millions of Americans.

But investors may be underestimate the damage that Washington budget battles could still inflict on the stock market. Mohammed El-Arian, CEO of the huge bond fund PIMCO, recently told Yahoo! Finance that "our problems are less economic in nature and more political. The biggest setback is that [Congress] fabricates problems."

El-Arian also said he thinks stocks are overvalued and poised to fall because the Fed policies that have helped inflate stock prices are becoming less and less effective over time. If enough big investors articulate such views, that alone would probably push stocks down--no matter what happens in the real economy.

Rick Newman's latest book is Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.

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