Stock Market: Can Good News Be Good News?

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There has been a lot of hyper-taper sensitivity of late, ever since Fed Chair Ben Bernanke broached the subject of reducing the monthly $85 billion bond-buying stimulus program during the spring. With a better-than-expected ADP jobs report on Wednesday and a weekly jobless claims figure on Thursday, everyone (myself included) was nervously bracing for hot November jobs number on Friday. Why fret about potentially good economic numbers? Firstly, as a money manager, my primary job is to fret, and secondarily, stronger-than-forecasted job additions in November would likely feed the fear monster with inflation and taper alarm, thus resulting in a triple-digit Dow decline and a 20-basis-point spike in 10-year Treasury rates. Right?

Well, the triple-digit Dow move indeed came to fruition … but in the wrong direction. Rather than cratering, the Dow exploded higher by +200 points above 16,000 once again. Any worry of a potential bond market thrashing fizzled out to a flattish whimper in the 10-year Treasury yield (to approximately 2.86 percent). You certainly should not extrapolate one data point or one day of trading as a guaranteed indicator of future price directions. But in the coming weeks and months, if the economic recovery gains steam, I will be paying attention to how the market reacts to an inevitable Fed tapering and likely rise in interest rates.

The expectations game

Interpreting the correlation between the tone of news and stock direction is a challenging endeavor for most (see Circular Conversations and tweet), but stock prices going up on bad news has not a been a new phenomenon. Many will argue the economy has been limp and the news flow extremely weak since stock prices bottomed in early 2009 (i.e., Europe, Iran, Syria, deficits, debt downgrade, unemployment, government shutdown, sequestration, taxes, etc.), yet actual stock prices have chugged higher, nearly tripling in value.

There is one word that reconciles the counterintuitive link between ugly news and handsome gains: expectations. When expectations in 2009 were rapidly shifting toward a Great Depression and/or armageddon scenario, it didn’t take much to move stock prices higher. In fact, sluggish growth coupled with historically low interest rates were enough to catapult equity indexes upwards, even after factoring in a dysfunctional, ineffectual political backdrop.

From a longer-term economic cycle perspective, this recovery, as measured by job creation, has been the slowest since World War II (see calculated risk chart below). However, if you consider other major garden variety historical global banking crises, our crisis is not much different (see Oregon economic study).

EmploymentCalcRiskRecAlignNov2013

While it’s true that stock prices can go up on bad news (and go down on good news), it is also possible for prices to go up on good news. Friday’s trading action after the jobs report is the proof of concept. As I’ve stated before, with the meteoric rise in stock prices, it’s my view that the low-hanging profitable fruit has been plucked, but there is still plenty of fruit on the trees (see Missing the Pre-Party).  I am not the only person who shares this view.

Recently, legendary investor Warren Buffett had this to say about stocks (via Louis Navellier):

“I don’t have concerns about this market.” Buffet said stocks are “in a zone of reasonableness. Five years ago,” Buffett said, “I wrote an article for The New York Times that said they were very cheap. And every now and then, you can see that that they’re very overpriced or very underpriced.” Today, “they’re definitely not way overpriced. They’re definitely not underpriced.” Buffet added: “If you live long enough, you’ll see a lot higher prices. I don’t know what stocks will do next week or next month or next year, but five or 10 years from now, they are very likely to be higher.”

However, up cycles eventually run their course. As stocks continue to go up on good news, ultimately, they begin to go down on good news. Expectations in time tend to get too lofty, and the market begins to anticipate a downturn. Stock prices are continually incorporating information that reflects the direction of future earnings and cash flow prospects. Looking into the rearview mirror at historical results may have some value, but gazing through the windshield and anticipating what’s around the corner is more important.

Rather than getting caught up with the daily mental somersault exercises of interpreting what the tone of news headlines means to the stock market (see Sentiment Pendulum), it’s better to take a longer-term cyclical sentiment gauge. As you can see from the chart below, waiting for the bad news to end can mean missing half of the upward cycle. And the same principle applies to good news.

Good News Bad News1

Bad news can be good news for stock prices, and good news can be bad for stock prices. With the spate of recent positive results (i.e., accelerating purchasing manager data, robust auto sales, improving GDP, better job growth, and more new home sales), perhaps good news will be good news for stock prices?

Wade Slome, CFA, CFP, is president and founder of Sidoxia Capital Management and shares his investing insights at Investing Caffeine.

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