The stock market might soon be faced with the reality that it can’t keep talking to itself

According to experts, investors might be overthinking things a little bit.

“When you look at how interest rates have responded to inflation, that’s not what people expected,” mused Brad McMillan, Chief Investment Officer for Commonwealth Financial Network. “People are second-guessing the market as opposed to just reacting to the data.”

The three major indices did post their first weekly losses in five weeks on Friday with the Dow Jones Industrial Average DJIA, +0.50% dropping 0.6%, the S&P 500 SPX, +0.72% declining 0.3%, and the Nasdaq Composite COMP, +1.00% falling 0.7%, as investors at least partially digested macroeconomic pressures like soaring food costs, a corresponding plunge in consumer sentiment, and September data revealing a labor shortage the depth of which has not been seen since the turn of the millennium.

But even with that small weekly drop in stocks, which was helped along in large part by Disney’s weak quarterly results earlier in the week causing a dip in the Dow, all three indices bounced back on Friday to close higher and near all time records despite the economic blinking red lights and a bond market that appears to be taking the threat of inflation much more seriously than central bankers.

U.S. Treasury bond yields posted huge rises for the week, with the 2-year rate posting its biggest jump in two years, thanks to bond traders worrying about a U.S. inflation rate not seen since the 1990s and likely anticipating some response from the Federal Reserve.

But the chances of any Fed response denting the health of the stock market are far from clear.

“Bonds are interesting,” said McMillan. “As opposed to how this would normally work, Wall Street is talking to itself and asking; Can the Fed let interest rates go up right now?”

For months, investors have been caught up in the heady future of a post-pandemic economy with consumer spending surging back as people resume what used to be considered a normal life. That optimism has been reflected in quarter after quarter of surprisingly strong profit results from many sectors of the stock market, and investors have pinned their hopes on that trend continuing as the world bounces back from COVID-19.

However, as Citadel founder Ken Griffin mused at last week’s Dealbook conference, Fed chair Jay Powell’s line on the transitory nature of inflation has gotten “long in the tooth”, and so with a wickedly clogged supply chain and inflation that does not look all that transitory after all, equity investors might have to soon stop pricing in their own thoughts on the markets and surrender to economic reality.

“Stocks have been on a strong run thanks to a knockout earnings season but with that winding down, investors will have to look elsewhere for positive catalysts,” wrote Craig Erlam, Senior Market Analyst at OANDA, in a note on Friday. “The economic data may offer some cause for optimism, like last week’s jobs report, but even that comes at a cost. Still, better than stagflation.”

Or as Commonwealth Financial Network’s McMillan put it, “Inflation is part of the cognitive disconnect. What happens if inflation reverts? Maybe everything goes back to normal, but that’s not happening anytime soon.”

Perhaps some better sense of reality might emerge from data this coming week such as October retail sales on Monday, October building permits and housing starts on Tuesday, and weekly jobless benefit claims on Thursday, but given current optimism and the high valuations in the stock market, maybe not.