Investors worldwide were holding their collective breath over the weekend worried about the elections in Greece, Egypt, and France. Greece, of course, was the primary focus. Many investors feared that the left-wing Syriza party would win the election and hasten the country's exit from the euro. However, Syriza lost to New Democracy, a more conservative party that has vowed to stick with the nation's previously made bailout agreements. However, New Democracy's victory was not decisive. As a result, it is trying to form a coalition with the third-place finisher.
Initially, markets were relieved. U.S. futures surged, indicating a strong open. But the gains fizzled out as investors began to realize that the election solves nothing. Greece is still in trouble. There is still a good chance it will abandon the euro, only later rather than sooner. Furthermore, Spain and Italy present even more serious problems.
The big mystery is not why the markets opened flat, but why they are holding up so well. The explanation has to do with the Federal Reserve. Investors seem to think that bad news is really good news, and that really bad news is even better. They reason that the worse things get in Europe, the more likely the Fed will come to the rescue by dishing up more stimulus. One concern I've had for a long time is that stock market rallies are being fueled not by improvements in the economy, but by Federal Reserve stimulus. The Fed, however, is like a drug dealer delivering a temporary fix. The Fed cannot address the real problems in the economy. That will require Congressional action. For example, a complete overhaul of the tax code would help matters tremendously. Congress could start by simplifying the tax code. It should eliminate deductions and reduce tax rates. But with an election just months away, it's a sure bet that Congress won't do anything.
We'll hear more from the Fed on Wednesday. Some investors are betting that Ben Bernanke will extend "Operation Twist," the Fed's attempt to bring down long-term interest rates. Unfortunately, the economy's troubles have nothing to do with high interest rates. Nonetheless, the markets may rally in reaction to whatever action the Fed announces. Stock market rallies are nice, but they won't solve the real systemic problems in the economy.