Stocks appear detached from reality, rallying for two things that may not happen

The new year is not even three full weeks old, and already half a trillion dollars has been added to the S&P 500‘s value. Some investors worry either the economy has to suddenly jolt into action or earnings have to surprisingly surge — two things unlikely to occur — in order to justify these kinds of gains.

The S&P 500 has soared 12% since the beginning of October. Not only does the rally defy many tried-and-true economic indicators, it also ignores the ongoing profits slump, leading many Wall Street strategists to urge caution.

“People are getting too optimistic in the short-term,” said Tom Essaye, founder of The Sevens Report. “We keep pricing in all this really good stuff that’s going to happen, but it has not shown up yet …This market is in a full melt-up mode, and it would be foolish to try and stay in front of it.”

Perhaps the easing trade tensions between the U.S. and China unleashed animal spirits, or the Federal Reserve’s massive bond-buying is working its magic. But if the rally is purely driven by expectations for a rapid rebound in earnings growth and the global economy, this level of enthusiasm should elicit concerns.

The problem front and center is how investors are looking past the continuous earnings rout, betting on a snapback as soon as the first quarter of 2020.

S&P 500 earnings are expected to drop by 0.3% in the fourth quarter of 2019, marking the first back-to-back quarterly decline since 2016, according to Refinitiv. Analysts project much higher earnings growth in 2020, a 6% increase in the first quarter.

“It just seems obvious to me that we’ve had a situation where earnings have gone nowhere and the markets have gone straight up,” said Matt Maley, chief market strategist at Miller Tabak. “I don’t want to call it a bubble yet but it’s moving in that direction. The market is way ahead of its earnings.”

The stock market and the economy are also telling two different stories, at least for now.

The U.S. manufacturing sector has been contracting since August as exports dropped amid the China trade war. However, the gloomy readings on the key industry didn’t prompt investors to take shelters. Instead, stocks kept rising to new records.

While megacap tech giants lift the market higher, more economically sensitive pockets of the market continue to fall behind. S&P 500 materials and consumer discretionary only eked out 6% and 4% gains, respectively, in the past three months, versus the broad market’s 11% climb.

Meanwhile, a century-old classic tool known as Dow Theory has yet to confirm the rally is for real. The Dow Jones Transportation Average hasn’t hit new record highs with industrial stocks consistently underperforming over the past year. Many believe transportation stocks are a barometer of global economic activity and any rally without their support cannot be a long-lasting one.

Some strategists floated the theory that the rally is driven by the Federal Reserve’s commitment to providing liquidity in the short-term borrowing market for banks, known as the “repo” market.

On Oct. 11, the central bank announced it would begin purchasing $60 billion of Treasury bills a month to keep control over short-term rates. The magnitude of the purchases resembles the quantitative easing program the Fed conducted during and after the financial crisis.

“The primary driving force behind the advance is increased liquidity/money flows — massive injections of funds into their systems by central banks,” David Rosenberg, chief economist and strategist of Rosenberg Research, said in a note.

The increase in the Fed’s balance sheet has been in near lockstep with the stock market’s climb. The balance sheet has expanded 10% since October, while the S&P 500 shot up 12%, including notching its best fourth quarter since 2013.

“Whether one wants to call it QE or not, we believe this excess liquidity has suppressed volatility to extremely low levels,” Michael Wilson, Morgan Stanley’s chief U.S. equity strategist, said in a note. “A liquidity driven bull market typically overshoots fair value.”

The pillars of the record-long bull market are standing taller than ever. The top five U.S. companies — Apple, Microsoft, Alphabet, Amazon and Facebook — now claim 18% of the S&P 500 market capitalization, the highest percentage ever, according to Morgan Stanley.

Apple is still doing the heavy lifting, soaring 12% in the past month and making it the best performer in the Dow Jones Industrial Average. The bigger is also the better — The 50 largest stocks in the S&P 500 are up 1.2% on average this year, according to Bespoke Investment Group.

Technical investors including Commodity Trading Advisors are adding to their long positions in S&P 500 futures “at a furious pace,” Nomura’s macro and quant strategist Masanari Takada said. CTAs are trend-following quants that trade futures contracts and commodity options.

“It appears to us that the market is letting itself slide back into a euphoric mood,” Takada said. “We think that this sprint to chase the market’s upward momentum is giving rise to a systematic market melt-up.”

To be sure, if the Fed keeps adding stimulus to the market and the economy gets a boost after the election is over, then perhaps the gains will be justified.

But November is still a ways off and a lot can happen between now and then, especially with an ongoing impeachment trial and growing geopolitical tensions.

— CNBC’s Nate Rattner and Michael Bloom contributed to this report.