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Why the markets keep chugging inside 'Fortress USA'

Call it a Fortress USA mentality—the stock market hitting new highs while the news abroad ranges from economically dismal to militarily gruesome.

Russian forces roll into Ukraine amid news of beheadings in Iraq from one of the most brutal terrorist groups the world has ever seen in the heart of the world's oil production and the market shrugs it off. All of this while Europe, the world's biggest economy, teeters on the verge of recession and the Federal Reserve comes ever closer to exiting its zero interest rate policy.

Behind this oblivious march higher, at least three assumptions appear to have taken hold, all of which speak to a general attitude that the U.S. economy and its stock market can withstand the global mayhem.

First is the assumption that neither Ukraine nor ISIS represent much of a threat to profits and economic growth, despite the oil and energy connections to both regions. Second is that the U.S. and Europe can embark on different growth paths, with US growth unaffected by European weakness. And third, underlying all of it, is a sense that the Federal Reserve can execute an exit strategy in coming months before inflation takes off and without creating a major recession or market plunge.

Traders on the floor of the New York Stock Exchange.
Lucas Jackson | Reuters
Traders on the floor of the New York Stock Exchange.

To be sure, the markets' attitudes can change quickly from calm to fear on each of these issues and some big-time investors aren't so sanguine: "Do you remember another time when there were more issues going on around the world? All at the same time? Any one of which overnight could turn into a major disaster?" billionaire real estate mogul Sam Zell told Squawk Box Wednesday morning. "You want to talk about ISIS, you want to talk about Gaza, you want to talk about Ukraine, Venezuela—I mean there's so many. I don't remember any time in my career where there have been as many wildcards floating out there that have the potential to be very significant and alter people's thinking."

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Responding to Zell several hours later, normally bullish Jim O'Neill said: "I don't feel my normal usual bullish self…. I can't remember the start of a sort of back-to-school season in finance where there were so many very complex issues around the world—which are very unpredictable. But on top of that, and ironically of course, with the evidence of the U.S. economy strengthening more and more, we're going to be creeping towards a position here where the Fed may get even less dovish than it has been recently which could cause bond yields to rise earlier

So how realistic is the Fortress USA mentality?

Iraq, Russia and Oil

One of the biggest surprises amid the geopolitical mayhem has been the fall in the price of oil. West Texas prices has declined from $106 a barrel in mid-June to $93 today. The drop is all the more surprising when considering that such Mideast headlines in the past have caused prices to surge. Lots of technical factors and seasonality move oil prices, but it's also clear there have been tectonic changes in how America sources its oil.

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In 2000, less than 50 percent of U.S. oil consumption was sourced in North America, from Canada, Mexico and the US itself. That percentage today is close to 70 percent. Meanwhile, OPEC now provides less than 20 percent of U.S. oil, down from 30 percent at the beginning of the century. So, the sources of U.S. oil are from increasingly more stable countries, which could be responsible for less volatility surrounding the horrific foreign headlines.

Global Weakness

Earlier this summer, the International Monetary Fund shaved two-tenths off its global growth forecast for 2014, bringing it down to 3.4 percent, because of weakness just about everywhere: China, Europe, Russia and even the US. Since then, second quarter German economic growth came in with a 0.2 percent decline but US growth has been revised higher to 4.2 percent. Third quarter growth estimates for the US continue to hover around 3%.

Behind these forecasts is a sense that the U.S. has momentum in manufacturing and that job creation has turned a corner. Expectations are high for a seventh month of 200,000-plus job growth in the Friday jobs report for August. There also seems to be generally agreement that the European Central Bank will take actions beyond what it has already announced to address both its low growth and inflation, possibly including an American-style quantitative easing program.

In a recent research note, former New York Fed official Krisha Guha, now a central banking analyst for ISI, wrote: "We believe the ECB is likely to end up in QE (60 / 40 probability) but do not believe the Governing Council will get there very quickly (base case December)."

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Once the program starts, Guha believes the ECB will be all-in. "…(D)e facto any program would in our view turn out to be open-ended" since the ECB can't announce a fight against deflation and stop in the middle.

Though both are highly uncertain, the combination of potential European QE and US growth momentum seems to be the cornerstones on which the case for continued US earnings growth and higher stocks prices is being built.

Fed Exit

For what will be an historic exit from an historic monetary policy program, fixed income markets are trading with surprising equanimity. The Fed funds futures market predicts the central bank will peg its rate at just 72 basis points by the end of 2015, and has been in the same range for months, suggesting little volatility around the forecast.

According to the CNBC Fed Survey in July, 34 percent of respondents think the Fed's extraordinary monetary policies will end badly and an equal 34 percent think it will end smoothly. For about a quarter of respondents, the odds are even.

While the headlines and research reports are full of warnings of disaster from the Fed's exit, surprisingly little money is being bet on that outcome. That could be mean a massive shift once the Fed actually telegraphs a rate hike. But for the moment, most are fairly certain it's coming and no one seems to want to do very much about it.

—By CNBC's Steve Liesman. Follow him on Twitter: @steveliesman

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