Call it the "great" recession. Lombard Street insists the U.S. slipped into recession in the second quarter as the full brunt of the budget cuts known as the sequester hit. Even the rosiest of forecasters acknowledge growth slowed sharply from the first three months of the year. And yet major U.S. stock indexes continue swaggering to fresh all-time highs.
Contradiction? Not quite. It is precisely because growth continues to underperform that the Federal Reserve can and will keep interest rates at record lows and its supplemental bond-buying program in place.
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And that guarantees two things: first, that investors—especially pension funds which need to hit annual return targets north of 5 percent—will continue to pile into riskier, higher-yielding assets; and second, that companies able to take advantage of these super-low borrowing costs will continue issuing debt to buy back shares of their own stock, supporting both their individual performance and that of the broader market.
No wonder investors describe it as a hold-your-nose-and-invest kind of environment. Voodoo shop? You bet, says Brian Reynolds of Rosenblatt Securities; but "we think this boom will go on for years to come because of those [pension] cash flows." A new acronym—FOBOR, or FOrced Buyers Of Risk—is making City rounds. Even the old Chuck Prince line ("As long as the music is playing, you've got to get up and dance") is becoming alarmingly common again.
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The squeamishness is understandable. When the S&P 500 first closed above 1,000 in February 1998, U.S. growth had averaged 3.9 percent in the prior year and would go on to peak at 5.4 percent on a rolling four-quarter basis two years later. By contrast, in this same quarter that the S&P has just punched through 1,600, the U.S. will be lucky to avoid contraction. Growth through the March quarter averaged just 1.8 percent. A sustained pickup to even 3 percent for now looks unlikely.
It is fair, in other words, to claim today's stock market rally isn't built on as solid a foundation. But there are two key reasons it still doesn't appear to be on the verge of collapse. First, the buyback phenomenon, of which Apple's record-busting corporate debt offering is only the latest example. Second, the fact that fiscal drag as opposed to the end of a business cycle is largely behind the economy's summer swoon.
There is both technical and fundamental support, that is—for now. One or the other will have to give before investors seriously rethink the rally; either a rebound in benchmark rates driven by brighter growth prospects that shakes people out of riskier assets or signs that the business cycle is taking a turn for the worse.
As for being stuck in the pretty glum middle? Turns out it's just the place for stock-market glee.