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Maybe Jim Flaherty's not such a bad guy after all. The stock market certainly seems to have forgiven him.

In the past three trading sessions, Canada's benchmark stock index has recouped nearly all of the 294 points its lost the day after the Finance Minister slapped a tax on income trusts. In fact, for most of yesterday, the S&P/TSX was trading above its premassacre levels.

It's hard to say what was more surprising -- Mr. Flaherty's decision to tax trusts, or the market's dramatic recovery since.

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"If you told me that less than a week later the market would have regained all its losses I wouldn't have believed it, but indeed that's exactly what's happened," said Patricia Croft, who helps oversee $60-billion as chief economist at Phillips Hager & North Investment Management in Toronto.

What accounts for the rebound? A couple of things. First, yield-hungry investors who yanked billions out of income trusts have put their cash back to work in conservative dividend-paying stocks such as banks, insurers and pipelines. For example, since the trust bomb exploded, Royal Bank has surged 4.2 per cent, Manulife Financial 3.9 per cent and TransCanada 2 per cent.

"Dividend stocks are looking attractive in light of what happened last week. The whole search for yield will benefit them," Ms. Croft said.

Second, investors have surveyed the battered trust landscape and concluded there's hope after all, given that many units are now trading at tempting valuations and taxes won't kick in until 2011. In the past two sessions alone, the S&P/TSX capped income trust index has jumped 6 per cent.

"Investors are taking a more realistic view of the situation. It's going to be four years before the existing trusts are taxed and anything could happen in those four years," said Elvis Picardo, chief market strategist at Global Securities Corp. in Vancouver.

The recovery was in full swing yesterday as the S&P/TSX composite index -- which has roughly a 10-per-cent weighting in trusts -- gained 94.24 points or 0.8 per cent to 12,333.28. It's now just 11 points shy of its close of 12,344.59 on Oct. 31, before Mr. Flaherty's surprise announcement.

The second-biggest contributor to the index's gain yesterday was Canadian Oil Sands Trust, which jumped 6.3 per cent as the price of oil rose above $60 (U.S.) a barrel, driven by a report that the Organization of Petroleum Exporting Countries may cut production and by an attack on a production facility in Nigeria.

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The heady pace of deal making is also giving stocks a lift, as illustrated by yesterday's $3.4-billion (U.S.) offer to take Four Seasons Hotels private and Kinross Gold's $3.2-billion bid for Bema Gold. Four Seasons and Bema were the biggest gainers on the S&P/TSX yesterday, leaping 29 per cent and 10.6 per cent respectively.

Stocks also got some support from south of the border, where the Dow Jones industrial average snapped a six-session losing streak, climbing 119.51 points or 1 per cent to 12,105.55 -- its biggest gain in a month.

Wall Street drew encouragement from Michael Moskow, president of the Chicago Federal Reserve Bank, who said he expects the U.S. economy to bounce back after growing at just a 1.6-per-cent annual rate in the third quarter. He also played down worries that a slump in housing will drag the economy into a recession.

"Home construction is on average only about 5 per cent of [gross domestic product] That's about the same as people spend on recreation items such as books, golf clubs, and tickets to theatre and opera," Mr. Moskow said.

"Currently, we do not see the slowing in housing markets spilling over into a more prolonged period of weakness in the U.S. economy over all."

Apparently, Canada's trust selloff is not about to tip the stock market into a prolonged decline, either -- as long as solid earnings continue to roll in and the mergers and acquisitions game stays hot.

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"The markets in Canada and the U.S. have displayed tremendous resilience over the last three months and I think the sense of optimism is still at play here," Mr. Picardo said.

jheinzl@globeandmail.com

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