The stock market celebrated the extension of the Bush-era tax cuts last week. The Dow was fairly flat, but most other indexes reached new 2010 highs. The S&P 500 rose 1.3% last week, reaching its highest level since September 19, 2008, just after the Lehman Brothers collapse.There is also a rally brewing this week, based on Monday’s move upwards and strength today.

Small stocks fared even better, as the “January Effect” seems to start earlier each year. Last week, the S&P Small Cap index and Russell 2000 rose 2.5% and 2.7%, respectively, and have been outperforming this week as well.  Some of the new tax code provisions — namely breaks for business investment and a $120 billion payroll tax holiday — are expected to spark new economic growth, causing many economists to revise their 2011 GDP forecasts upward, to as high as 3.5%.

Treasury Bond-Market Collapse Fuels a Continuing Stock Surge

So what’s behind the gains? It’s a host of reasons, but here are a few:

My favorite economist, Ed Yardeni, recently pointed out that the Fed’s first round of quantitative easing was designed to encourage investors to buy bonds. However, Yardini pointed out that the Fed’s second round of quantitative easing now appears to be pushing investors out of bonds and into stocks. Yardini was in London last week, reporting that Europe is now jumping on the quantitative easing bandwagon.

The Bank of England, the Bank of Japan, the European Central Bank – as well as the Federal Reserve – are all pumping money into their respective bond markets via quantitative easing and are willing to do “whatever it takes” to shore up their respective economies. This money is definitely spilling over into the stock market as the risk of rising bond yields (falling bond prices) is pushing investors out of government bonds and into other assets. Since the stock market is typically the first choice of investors running from bonds, we are in a very bullish environment for stocks, especially as GDP estimates are revised higher.

Opponents of the recent tax bill say that it will add another $1 trillion to the federal budget deficit in the next two years, on top of the already-huge (and growing) monthly budget deficits in recent months. On Friday, the Treasury Department announced that November’s federal budget deficit hit a record $150.4 billion. November was the 26th straight monthly deficit and, worse yet, it came in $45 billion higher than November of 2009, so the U.S. budget deficit is spinning out of control – with or without a new tax bill.

Whether the tax bill passes now or later, investors realize that +$1trillion dollar annual deficits are now a permanent fixture for as far as anyone can see (even the White House is forecasting a $1.416 trillion deficit for fiscal 2011). Despite the Fed’s QE-2 policy of buying $600 billion in Treasury debt, Treasury bonds had their worst weekly performance this year as yields rose dramatically last week. The 10-year Treasury bond yield is now up to 3.32%, almost 1% above its October low of 2.41%. Meanwhile, 10-year bond yields in Britain, Germany and Japan have also risen 18% to 29% in the last five weeks.

As long-term bond yields rise and bond principal erodes, the move out of bonds and into stocks should continue. Consumer confidence and stronger GDP growth will also help to inspire confidence in the U.S. economy and the stock market. One thing I have learned in the past 30+ years in this business is that sometimes you have to wait patiently for inflection points.

Now that many investors are fleeing bonds and moving into stocks, this could be a strong inflection point, sparking a long and strong stock market rally.