The old lore about the best way to cure a hangover is with a few more nips of whatever it was you were imbibing the previous evening, commonly known as "hair of the dog."

The extension of this rally in stocks and just about every other asset identified with risk feels like a hair-of-the-dog situation. Between 2003 and mid-2008, easy flow of capital facilitated revelry in stocks, emerging markets, real estate, bonds, and high-yielding currencies.

REUTERS/Brendan McDermid

When investors invariably lost interest in an asset class where valuations could no longer be denied, they flocked to another - witness $150-a-barrel oil, $1,000 gold prices, and crazy gyrations in wheat and soybeans, of all things.

Then the hangover came. Major stock indexes were cut in half. Oil went to $30 a barrel, and investors fled for cover in the dollar and the safety of Treasury bonds.

With U.S. Federal Reserve and other central banks cutting rates to nothing, money worked its way back into the markets, though.

And how: Bespoke Investment Group notes that the S&P's charge has lifted it to its highest level above its 200-day moving average since 1983, just six months after it hit its lowest point below that average since 1932 - something that's only happened three times. The Australian dollar is up 23 percent against the dollar this year.

Want more? China's SSE Composite has gained nearly 70% since hitting a low late last year. Options action has been massive in recent days as investors concentrate bets on momentum-oriented names. The party line on Wall Street is that markets are reconsidering their view of risk, but recent reports noting investment bankers' newfound interest in securitization of life insurance settlements (surely nothing can go wrong there).

The fear, of course, is this: that the eventual unwind of government stimulus, low interest rates, and protective efforts for large financial companies will reveal a shell, one where economic activity and market gains prove to be a mirage. With some investors still cautious - U.S. money market fund assets, while lower, are still high - it doesn't take much imagination to see that a few extra nips could bring on another nasty hangover. Until then, party on?

So who is right and who is wrong?The stock market has rallied by more than 50 percent in the last five months. But bond market yields currently hover around 3.4%, and while that's nowhere near close to the crisis-induced record low reached at the end of 2008, a graph of the 10-year note's yield shows that it remains lower than almost any point other than when prices spiked in the wake of the Lehman Brothers collapse.

Ten-year yields remain in a tight range.

Equity investors would rightly point to better housing data and stronger economic indicators as a sign that things are looking up. The bond market, meanwhile, continues to worry that the outlook remains grim. Yields have been bound in a range between 3.4% and 4% since late May, despite the dark warnings from those "bond vigilantes" that believe crushing U.S. debt will turn off our major foreign benefactors.

But a rally in both the bond and stock markets was a fixture of the financial scene for a number of years. Strong growth coupled with low inflation created the so-called Goldilocks scenario, where bond yields could rally, and stocks flourished in part due to lower borrowing costs.

Whether that can be repeated for any length of time remains to be seen. Stocks have rebounded from an awful several months but still remain about one-third below their peak. Yields are low, but 3.4% has been the floor, even with the inducement of the Federal Reserve buying Treasury securities.

The possibility exists that in coming years both stocks and bonds will deliver mediocre returns. Bonds have benefited from the intermittent breakouts of risk aversion that accompany bad economic reports or brief stock swoons. And it seems less likely that equities can keep running at this pace with the outlook for earnings - particularly profit growth - so unsettled.

It used to be that Citigroup was one of the market's most important stocks, if not the most important. At the nexus of the banking, securities and lending industries that benefited most from the easy-credit boom of the middle of the decade, its success as a stock mirrored the market and the economy.Somewhere around 2006, when people started to call for a breakup of the company, it was supplanted by a company even more tied to the derivative-fueled mess that masked the holes in the economic landscape - Goldman Sachs.

But Goldman continued to earn massive profits while Citigroup nearly died a painful death. Shares eventually fell to less than $1 a share, it was kicked out of the Dow and investors started to view other consumer banks as better indicators of the market's health.

Still, there's a chance that Citigroup may become more important once again, provided it survives (with substantial help from the government). Kevin Depew, recently writing on Minyanville.com, noted that most of Citigroup's short-term debt has returned to spreads present before the blowup of Lehman Brothers, suggesting that bond investors believe the debt crisis has receded. He notes (using a bit of technical analysis) that "Citigroup right now might again be The Most Important Stock in the Universe."

But one could argue it never stopped being important . It's clearer now that those in search of a proxy for the economy, investors should have stuck with Citigroup all along. (Not that they should have stuck with owning the shares.) Its plunge came at a time when many thought a second Great Depression - or something close to it - was on the way, and its status as a ward of the state mirrors the economic situation as well: second-quarter GDP would have been worse had it not been for government spending.

Shares of the stock continue to struggle. It trades at less than $4, but the company recently saw a boost in trading volume as a result of an increase in its influence in the S&P 500. This may increase again if certain preferred shares held by the government are converted to common stock and then end up in the public's hands.

The market can't be blamed for ignoring Citigroup, washing their hands of it as it slumped.

But Citigroup never stopped being a bellwether for the economy. Its likely path in the next several years: slower growth, forced reduction of leverage, and government help, is the one the broad economy is likely to follow.

Eventually, when the banking system is smaller, and has delevered, and consumers and businesses have pulled out of the mountain of debt piled on over the years, Citigroup will be just another company. Until then, the health of the economy is the health of Citigroup.

Five things to think about this week:

GOOD RUN 
-  Stocks have managed to extend their rally but potential hurdles, such as this week’s U.S. non-farm payrolls, could prove increasingly hard to leap given valuations — European stocks are trading at their highest multiples of earnings since May 2008 while the multiple for the S&P is the highest since mid-September 2008. If investors are to boost equity holdings — which Reuters polls show already back to pre-Lehman levels — it may require more concrete evidence of economic expansion, rather than just economic stabilisation, and signs that profit margins will be supported by revenue growth, rather than cost cutting. 

BOE - HANGING IN THE BALANCE
- The Bank of England will have to decide this week whether to end its asset-buying programme or extend it. Concern about potential longer-term inflation implications will have to be weighed against the signs of economic weakness still manifest in recent Q2 GDP data. With economists split on the outcome, markets look set for volatility, not least as the MPC’s decision is likely to be viewed as a indication of when other central banks could start to halt/unwind their credit easing strategy. 

SQUARING CIRCLES
- The dexterity with which China can manage surging lending and potential price pressures without unsettling markets with any rapid reversal of stimulative policy is increasingly in focus and will have financial market and macroeconomic repercussions well beyond its borders and Asia, as last week showed. Australia, which felt the spillover effect of the China jitters, has its own policy dilemma as the RBA is trying to push back against its currency’s appreciation while giving markets another reason to buy A$ by its more upbeat view on the domestic economic outlook. The RBA policy meeting this week will give the central bank a chance to show how it squares this circle. 

INVENTORIES AND EXPORTS 
- Detailed PMI data and UK, Italy industrial output reports will be scanned for signs of whether the inventory decline that accompanied a rise in Japanese industrial output is being seen elsewhere, with the inventory-shipments, inventory-orders ratios remaining firmly in focus as key signals for the outlook for production. The extent to which Asian economic activity is helping trade flows will also be flagged by German and French June trade data (all the more interesting given May exports rose in both countries, despite their differing export specialisations.

LOAN PROVISIONS 
- European banks reporting this week will be closely watched for the extent to which they follow in Deutsche Bank’s footsteps by making higher loan loss provisions. The ECB’s latest lending survey shows euro zone banks’ expect to continue to tighten credit conditions in the coming months, albeit at a slower pace; heftier loan provisions will make this all but guaranteed.

Investors have been cock-a-hoop about the latest earnings season — and probably with some reason. There has been positive surprise after positive surprise, particularly in America. Thomson Reuters latest research shows that of the 337 companies in the S&P 500 that had reported through Friday, 74 percent came in above analysts expectations.

A wag might suggest that this only means that analysts are not very good. Chances are, however, that it reflects that they overshot in their pessimism, a not unusual factor. Are they now being overly optimistic?

Investors are now buying away and putting bad news to one side. Consider as one example how the ballooning of bad debts in European banks have not stopped the sector from rallying sharply.

Rupert Robinson, chief executive at Schroders Private Bank, is one of those who have injected a note of caution into the earnings euphoria. Speaking primarily of  FTSE 100 index, which is up 35 percent since a March low, he says:

“One should not lose sight of the fact that the reason profits have come in ahead of expectations is cost-cutting –- not top-line revenue growth. Cost-cutting means higher unemployment and less consumption. Less consumption means less final demand, and therefore top-line growth is likely to remain very sluggish.”

Robinson says that investors need to see real evidence of stronger economic activity feeding through into corporate earnings for signficant progress to be made from here. He is looking more closely at defensives than he was and excpects a market consolidation or correction is likely.

But he too is relatively bullish. He says the FTSE could well hit 5,000 – about 7 percent above todays levels – in the first quarter of next year.

The S&P 500 index is approaching 1,000, Nasdaq is nearing 2,000, the Nikkei is above 10,000 and Dow could surpass 10,000 soon.

Welcome to the world of milestone mania, where investors give emphasis on nice round numbers.

U.S.-based wealth management firm Fisher Investments give a few thoughts on the milestones and the danger of having blind faith in them.

In ancient Rome, Emperor Augustus placed a pillar in the centre of the Forum, marking the starting point for a system of roads. The roads were marked every mile, or the distance covered in 1,000 paces (mille is Latin for 1,000), by a stone. These milestones became important markers to travellers, helping them sense the distance between two points and determine how far they travelled in relation to Rome.

“In investing, however, milestones are simply misleading. What do markets know of milestones—of beginnings, distance, and endpoints? Nothing—numerical milestones are meaningless to markets and have no historical forecasting power whatsoever,” Fisher says.
“If markets start creeping toward those higher, round numbers, don’t be surprised if technical analysis enthusiasts appear out of the woodwork, attributing vital significance to those levels—claiming reaching or not reaching those markers will show how markets will do going forward. This is faulty reasoning—ignore.”

How do those green shoots look now?The market got all a-giddy last week after Intel (INTC.O) and Goldman Sachs (GS.N) (a barometer of nothing other than its own ability to navigate turbulent markets) posted better than expected earnings, but the latest round of earnings reports points mostly to the ability of companies to tighten their belts to anorexic levels.

The Street celebrated when Caterpillar (CAT.N) reported earnings Tuesday, but the euphoria leaked out of the early market rally when investors got a second glance. Sales looked terrible as demand has plunged. They, along with Intel, Coca-Cola (KO.N), UTX (UTX.N) and others, are all using China as a crutch right now, thanks to that country's massive stimulus package. But building earnings strength on hopes that governments will continue to spend money isn't a winning strategy for years to come.

Meanwhile, the second quarter is emerging as a repeat of the first - applause for better-than-expected results, even if the surprises mostly come as a result of cutting jobs. According to Brown Brothers Harriman, 105 S&P companies have reported earnings as of this morning. Just 27 have reported positive year-over-year revenue growth - but 36 have reported positive earnings growth. In addition, when financials are removed from the picture, companies, on the whole, are falling short of sales expectations, with an average miss of 0.9 percentage points, but beating earnings expectations by 9.2 percentage points.

And yet, stocks continue their winning ways, with the Nasdaq threatening to make it 11 days in a row. Some believe this increases the chance that the market will correct, and violently so, when the gains can no longer be sustained. It may take until the third quarter to find out whether we've got an Ethel Merman market - everything's coming up roses - or a Lt. Hurwitz market, which just thinks it's Ethel Merman.

Sure, things look rosy for Goldman Sachs (GS.N), but the firm hardly represents the broad U.S. economic situation, as investors are looking over a mélange of lousy data, with dribs and drabs of mildly encouraging information in the mix.

Tuesday's retail sales figures weren't all that great - the strength comes from auto sales and rising gasoline prices (and rising gas prices aren't exactly great for consumers) - and Wednesday's data on capacity utilization and energy inventories are likely to confirm the ongoing slack in the economy.

So what to make of the statements from CSX Corp. (CSX.N) chief executive Michael Ward, who told Reuters the worst of the recession has been seen? Data on capacity utilization doesn't suggest a pick-up in demand, and the giant inventories of distillate products in various parts of the country also suggest the economy is sputtering, not chugging.

Weekly data on energy product inventories will be released Wednesday. Notably, distillate stocks - that's diesel fuel, jet fuel and heating oil - were at 158 million barrels as of the July 3 week, or about 55 million barrels above normal. Of particular interest is the inventory of low-sulfur diesel located on the western U.S. coast. Refining production has been in decline here over the past year, but inventories have not been drawn down to any great degree.

In a strong economy, stocks would likely fall - but they're not, despite declining refinery output, because of slack consumer demand for imports that come into Pacific ports. "If we're not seeing a material drawdown in supply, I would think that's indicative of weakness in overall demand in the market," says Stephen Schork, who writes the Schork Report, an energy market newsletter. "We're simply not manufacturing this stuff right now."

Data on rail traffic is no more encouraging, with North American rail freight down 20 percent in the first half of the year when compared with 2008. Ward of CSX predicted that third-quarter volumes will fall by double digits, but the pace of decline will be lower than this quarter, when it reported a 21 percent drop in freight volumes. So we're back to the second derivative again - the rate of change may be improving, but the underlying numbers are still negative. Another quarter or two, and we'll see if the economy is picking up steam, or if Michael Ward was blowing smoke.

On some level, every quarter is a make-or-break earnings season, and maybe that’s particularly true for the midsummer earnings season, as it comes at an otherwise quiet time for the broader markets.

But as investors get ready for Alcoa’s ‘kick-off’ of earnings season (and really, Alcoa serves as a nice beginning more for its symbol’s position in the alphabet than as any barometer for earnings), there may be something to all of the fretting this time around. After all, investors endured an awful fourth quarter, where the entire S&P collectively managed to lose money on an operating basis (thanks, AIG, and Citigroup, and GM, and, um…), and a first quarter mostly notable for a slightly better performance than expected - even though earnings were down 36% from the previous year.

It’s still hard to see where the improvement is going to be, however. Earnings are expected to fall about 36% once again, and investors in recent weeks have finally cottoned to the idea that vaulting over low bars really isn’t much to get optimistic about. If the market is truly going to turn higher, it will depend on the quality of earnings, and there, some aren’t so optimistic. Mike Lewitt, president of Harch Capital Management, said, “I don’t think there’s a lot of revenue growth, just shrinkage - basically everybody is shrinking across the board and that’s what we’re seeing.”

The hope, somehow, is that consumer demand is starting to rebound, however slightly, as people get used to the new economic reality - relieved to still have a job, and ready to buy goods after putting off purchases for some time. “Many people made decisions to postpone purchases but not forego them,” said Diane Garnick, investment strategist at Invesco.

We’ll see. What may be necessary is a bit of reading between the lines when listening to conference calls. Visibility is still limited, and executives aren’t going to be eager to put forth rosy expectations when the economy remains stretched. An outbreak of brutal honesty among top execs isn’t likely, but a bit of hesitancy in describing current business decisions would say a lot.

Five things to think about this week:

Q3 - CLUES AND CUES
- Global equity markets started the quarter positioned for economic stabilisation after a strong Q2 performance but, even so, EPFR data shows less than a third of the cash that flooded into money market funds in 2008 has exited in the year to date. The Q2 reporting season, which is about to kick off (Alcoa out this week), will show whether there are reasons for investors to draw down their cash holdings further. The U.S. data that came out before the long July 4 weekend held more negative surprises than positive ones, and macroeconomic confirmation of recovery will be needed to tempt more wary investors into equities.

BOND YIELDS
- Benchmark U.S. and euro zone bond yields broke lower after the U.S. non-farm payroll data but the VIX hit some of its lowest levels post-Lehman and a recent compression of intra-euro zone spreads has yet to go markedly into reverse. Which of these trends turns out to be sustainable will become more evident in the next few weeks, particularly as U.S. supply resumes this week with TIPS, 3, 10, and 30 year auctions.

L’AQUILA SUMMIT
- The slow-burning international reserve currency debate could pop up at the G8/G8+5 big emerging powers summit in Italy this week. China’s public stance is that it is not pushing the issue but Beijing also reckons a debate on this would be normal at such a forum. It is unclear if any final statement will mention it in a way that would rattle FX markets. But sideline comments on the debate will be closely watched and particular focus will be on which countries, if any, would be willing to join China, Brazil and Russia in their commitment to buying the IMF SDR notes — for which crucial groundwork was laid down this week.

FOLLOW THE MONEY
-  Questions remain over what use is being made of the 442 billion euros ($619.6 billion) of ECB one-year money that was pumped into the market. A spike up in overnight deposits clearly suggests banks are continuing to park a significant proportion of that cash at the ECB. Any swings in that data will be closely watched for signs that the money could be put to work in other parts of the rate/fixed income market — or maybe even filter through to the economy in the form of lending. The BOE will also be in focus, with clues sought on the outlook for its QE strategy.

COMMODITY RISKS
- Commodity price volatility looks to be on the cards. A rally in industrial raw materials risks tapering off unless a stronger economic rebound materialises soon, both in big emerging economies and their developed counterparts. For soft commodities, the focus is increasingly turning to the potential impact on harvests from El Nino weather patterns that are developing. Investors will have to decide whether they would be better off exposed to stocks linked to the metals/minings, which will at least earn dividends, or to the commodity itself — or neither. As for any spike up in food prices, the fallout would be even wider at the current economic juncture, and complicate both policy and investment decisions.

(Reuters photo: Santiago Pandolfi)