Financial markets, for the most part, are supposed to function as discounting mechanisms in which the future is reflected in current stock prices. If the expectation for the future is better than the present, prices may rise even in the face of bad news. If the expectation for the future is negative, prices may fall even in the face of very good news. But because the markets are often driven by emotion, it doesn't always work that way.
The clearest example of this dilemma was in 2007 and 2008 when it was becoming increasing clear that there were problems in the US banking system. These problems were so bad that they threatened the solvency of the global financial system and the global economy. After a brief correction in the summer of 2007 following the collapse of two Bear Stearns hedge funds that focused on sub-prime mortgages, the US equity markets went on to make new all-time highs in October of 2007. What was even more amazing was that after JP Morgan purchased Bear Stearns in March of 2008 for just $10 per share, the markets rallied and were within 10% of those all time highs by May of 2008. And we all know what happened a few months later.
The series of events to what has transpired in Europe between mid 2011 and today (mid 2012) are similar to the series of events that happened between the summer of 2007 and summer of 2008 in the US financial crisis. By now it should be clear that a financial crisis in Europe cannot be avoided (most of Europe is already in recession) and the global fallout from this crisis could be very serious. Despite this markets are rallying on the idea that the governments will be able to print more money and fix the problem. While we can't totally dismiss the possibility of the problems getting fixed, ask yourself - when was the last time any government actually fixed a serious problem? Exactly.
Ironically, perception is reality in financial markets until the reality becomes all too real. Once the reality hits there is the potential for a significant price adjustment in global financial markets. Unfortunately it is extremely difficult to predict when this reality check may occur - it could be in 2 months or 2 years. It will be important to keep an eye out for reality setting in.
