Why aren't stocks down more?

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With the European sovereign-debt crisis showing no signs of abating – indeed, with Italian bond yields now above 7 per cent, it seems to be getting worse – you may wonder why stock markets aren't showing more concern.

Stocks actually rose on Tuesday, even as Italian bond yields moved higher. And Wednesday's broad stock market decline, while ugly, is hardly a meltdown: The Dow Jones industrial average was down 2 per cent in midday trading, which isn't too alarming, and the index is still up about 12 per cent from its low in early October. Meanwhile, the CBOE Volatility index, widely seen as a fear gauge, has risen to 32, but that's well below its recent high of 48 in August.

If you're scratching your head over this relatively tame reaction to events, you're not alone. The Economist's Free Exchange blogger expressed puzzlement: "Has the roadrunner sprinted off the cliff but not yet looked down? Or am I missing something?"

Tim Duy, a blogger and economics professor at the University of Oregon, can't explain market irrationality. But he sees some similarities to 2007. Remember? Financial signals pointed to big problems ahead, yet stocks ignored the threat until 2008 – when all hell broke loose.

"By the middle of 2007 the TED spread" – a widely followed indication of credit risk – "was exploding, signaling enormous financial turmoil," Mr. Duy said. "Yet equities kept heading upward, fuelled by data that was just not that bad coupled with ongoing expectations that a solution was just around the corner. And now we find ourselves in almost the exact same position."

The stock market seems to be operating under the premise that authorities are working on grand plans to solve Europe's debt problems, that the European Central Bank will step in as a lender of last resort, easing concerns about sovereign defaults, and that Europe's problems will stay contained within Europe.

"I hope that is correct, but suspect it is not," Mr. Duy concludes. "And if it not correct, I don't anticipate equities will react until it is obvious corporate profits will suffer."