The Confidence Game

(MoneyWatch)  In the past weeks, we've seen two 200-plus-point rallies in the Dow. The first coincided with the news that a starving nation led by a Stalinist throwback cult leader had detonated a nuclear bomb on the Korean peninsula. The second came on the day that a century-old symbol of American industrial might and corporate leadership declared bankruptcy. There had to be some damn good offsetting news to make the market rise on those days.

What there was, in the first case, was a big uptick in the Conference Board's survey of consumer confidence, among other green shoots. That was followed, in the second, by a big vote of confidence in the Obama administration. I'm not a big believer in reading deep meaning into daily moves in the market, but this one made sense to me.

There can be no economic recovery without a recovery in confidence first. Think of all the things that you'll take as concrete signs of a rebound -- business investing again, households buying homes at higher prices, consumers spending on cars, restaurants and vacations. None can happen unless the actors in them are convinced that the future is going to be better than the past. People put money what they have faith in -- and don't kid yourself, modern capitalism runs on faith, not evidence.

You measure faith in the stock market by price/earnings multiple -- the price that investors pay for each dollar of earnings they're entitled to. If you're confident that today's earnings will lead to higher ones in the future, you pay more. So far, most of the spring rally has come from an increase in P/E, since outside of banking, there haven't been a lot of earnings. Eventually, confidence has to be confirmed by higher earnings, but -- in one of those self-reinforcing cycles that creates panics and euphorias -- you can't have higher earnings until people in the real economy get more confident.

Animal Spirits, a terrific book by economists George Akerlof and Robert Shiller -- the former a Nobel Prize winner, the latter the guy who coined the phrase "irrational exuberance" -- argues that free market economies are all about psychology. If confidence rises, stocks may follow first, but then might come car sales and home sales and then corporate profits. All of a sudden, the merely psychological turns into something you can take to the bank.