Just as the belief that home prices could never go down spawned a self-reinforcing buying spree, the fear of a never-ending recession causes the economy to freeze, which can cause worry to become reality. Fear begets fear. Panic begets panic. Confidence begets confidence. Bubbles feed on themselves.

From this point of view, it's encouraging to see the Consumer Confidence Index not only stabilizing, but also sharply rebounding. After bottoming out in February, consumer confidence is now the highest it has been since the financial tsunami began last September. Have a look:
                                                                                                                 

Month

Consumer Confidence

May 2009

54.9

April 2009

40.8

March 2009

26.9

February 2009

25.3

January 2009

37.4

December 2008

38.6

November 2008

44.7

October 2008

38.8

September 2008

61.4

August 2008

58.5

July 2008

51.9

June 2008

51.0

May 2008

58.1

What should you make of the sudden spike in confidence? Two points stick out:

  • Much of it has been caused by a massive stock market rally that makes people feel good. Better yet, the market rally itself is largely based on the idea that we've avoided the end-of-the-world scenarios.
  • Don't pop the champagne just yet -- confidence is up, but historically, it's still incredibly low.

Let's start with the first point: a massive stock market rally. Since its intraday low on March 6, the S&P 500 has gained about 36%. Companies like Wells Fargo (NYSE:WFC), Las Vegas Sands (NYSE:LVS), and Ford (NYSE:F) have achieved multibagger returns. Such massive moves ignite what economists call the "wealth effect," where an increase in wealth causes an increase in spending. The increase in spending validates the increase in wealth, and hence the boost in confidence becomes self-fulfilling.

The bad news is that while confidence has surged, it's still depressingly low. Going back to 1967, the average confidence reading is 96.4. In the recession earlier this decade, the lowest it ever got was 61.4. The February low of 25.3 was the lowest going back to 1967.

Another point to take into consideration is how much of the market surge is based on hopes that banks are out of the woods. Encouraging earnings reports by Citigroup (NYSE:C) and Bank of America (NYSE:BAC) caused some to believe that banks are in the clear, but the bulk of those earnings were manufactured out of accounting tricks and asset sales. If time tells that the recent rally is based more on hope than reality, consumer confidence could fall back to earth just as quickly as stocks.

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Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. The Fool has a disclosure policy.