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Summer surprise: Real rally or bout of euphoria?

Traders work on the floor of the New York Stock Exchange.
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The old Wall Street adage "sell in May and go away" has given way to "buy, buy, buy in July."

A 600-point rally in the Dow Jones industrial average has caught many on Wall Street by surprise and wondering if it's just a bout of euphoria or a durable bounce.

There may be something real underneath the rally — a series of economic and earnings surprises along with an important recalibration of the outlook for interest rates and the Federal Reserve.

The U.S. Citi Economic Surprise Index has swung from around -24 at the end of June to +25 now. The better-than-expected jobs report, along with improved housing data and consumer spending powered the 50-point swing.

The index gives no indication about the level of growth, or even the future of it, but it does suggest that forecasters and the market had to catch up with better data.

The CNBC Rapid Update (the median of Wall Street's GDP tracking forecasts) is running at 2.7 percent, suggesting a decent bounce back from the weak first quarter. Yet only one-month's data are in for the second quarter. Sustaining the growth rebound would seem to be an important pillar supporting current market valuations.

Earnings have constituted something of a surprise as well, albeit a tentative one. The market seems to be cheered by the 67 percent of companies beating estimates and the 59 percent beating revenue, according to Wednesday morning's report from Thomson Reuters. Both are above the long-run averages for beats.

It could yet go the other way as only 14 percent of the has reported. But there have been some notable marquee beats, including IBM, Goldman Sachs and Morgan Stanley, along with some better guidance for earnings growth later in the year.

The interest rate backdrop for the recent rally also has been a significant surprise. Yields on the 10-year benchmark U.S. Treasury have fallen about 20 basis points in the wake of the surprise Brexit vote at the end of last month.

The ensuing decline in mortgage rates has helped homebuilding stocks. And the fall in yields comes part and parcel with a rethink of Fed interest rate hikes this year. In late June, markets judged there was a 12 percent probability of a rate hike at the U.S. central bank's meeting next week. That's now down to zero. The chance of a rate rise in September has declined to just 18 percent from 33 percent in June.

Continued improvement in the economy and markets represents a risk as it could bring the Fed back into play. Such low probabilities of a rate hike this year suggest either pessimism about better economic data or a possible underestimation of the chance that the Fed would react to that better data with a hike this year.

One criticism of summer rallies doesn't apply to this one: the market is not higher on thin volumes. The volumes are about normal. So Wall Street traders may have gone away in May, but they are still trading from wherever it is that they are.