How far can this rally go?

What's the fuel that's been driving the December/January rally?

It can't be macroeconomics, that's for sure. The World Bank just cut its forecast for 2012 global economic growth to 2.5% from 3.6%. Sure can't be Europe, where Greece continues to slide toward default while the region as a whole slips into recession.

And it's hard to generate a torrent of optimism from fourth-quarter U.S. earnings. Banks have struggled to beat radically lowered expectations, and more than 40% of the 44 Standard & Poor's 500 Index ($INX) companies that have reported fourth-quarter earnings have missed Wall Street estimates.

So what is fueling this rally?

I think the data make it very clear -- it's the conversion of skeptics into, if not optimists, at least market neutrals. It's the changing of short sellers into short coverers, of stock mutual fund sellers into mutual fund buyers, and of bearish market gurus into bullish market gurus.

Which, of course, raises this question: What happens when there are no more skeptics? Does this market rally stall when rising share prices have converted too many bears to bulls and thus removed the biggest source of fuel for this advance?

The wall stocks need to climb

With the Standard & Poor's 500-stock index closing at 1,308 on Jan. 18, stocks are once again challenging their summer 2011 highs. Each time, though, on July 21 and earlier on July 6, stocks reached for the April 29 high at 1,364 but failed at 1,344 and 1,339, respectively.

To many investors, this market advance makes no sense. Greece and Portugal look poised for default. The eurozone is sliding toward recession. Even Germany, the strongest economy in the region, is slowing. On Jan. 18, the German government cut its estimate for 2012 growth to 0.7% from the October forecast of 1%. China, Brazil and most of the rest of the world's developing economies are slowing, too -- so much so that the World Bank just cut its forecast for global growth. U.S. growth in the fourth quarter of 2011 looks solid, with something more than 3% possible, but everybody with a subscription to The Economist is predicting a drop in growth in the first quarter of 2012.

But don't look at the macro or micro fundamentals. Look at the change in sentiment. Frequently, and I think this is one of those times, a shift in sentiment from one extreme to the other can create momentum that -- for a while -- can by itself drive a market higher or drag it lower.

The bulls have it

Take the figures on bullish and bearish investment adviser sentiment compiled by Investors Intelligence, for example. Back in early October, when the S&P 500 had plunged to a low of 1,099, only 34% of the advisers surveyed were bullish -- and a huge 46% were bearish. (By the way, an Investors Intelligence subscription costs $199 a year, but you can sign up for a free monthly newsletter. You can find a similar contrary sentiment indicator that tracks the bullish/bearish sentiment of members of the American Association of Individual Investors in publications such as Barron's.)

By the second week in January, the bulls made up 51% of the advisers in the survey and the bearish sentiment had declined to 30%.

Think of the effects of that shift. In January, you've got a slim majority of advisers saying "buy stocks" and only 30% (down from 46%) saying "sell."

You can see the effect of this shift in sentiment in recent numbers on mutual fund flows. In the week ended Jan. 11, U.S. mutual funds attracted the most money in almost two years, according to the Investment Company Institute. Investors put $753 million into funds that buy U.S. stocks. That's the first time since August that U.S. equity funds had net inflows.

You can also see the way in which a move from very negative to not so negative drives individual stocks, if you look at the figures for short interest in specific stocks. Take St. Joe (JOE, news), a timber-company-turned-Florida-real-estate-developer. On Nov. 2, 2011, the stock ended a long downward trend at $13.14 a share on a big reduction in the company's net loss in the third quarter to just $2 million, from a loss of $13 million in the second quarter.

The stock moved up steadily from there to $14.67 a share by Jan. 9 -- a gain of 11.6% in a little more than two months. And then it hit the rockets, climbing to $16.81 for a gain of 14.6% in a little more than a week.