What Does It Mean When Stocks Rally on Bad News?

It didn't happen yesterday when those terrible auto sales hit, but all through December and into the New Year bad economic reports actually sparked almost all of the Dow's recent rally from November lows.

In fact, all the Dow's gains since November 20 came on just six trading days when depressing data (sinking home prices, a dismal employment report, a terrible ISM manufacturing number) sent stocks up by triple digits. That's according to Merrill Lynch economists who find it "absolutely fascinating that since equities bottomed on November 20th, the Dow has managed to rack up 1,482 rally points. And, they all managed to come on days when the data could hardly have been worse."

[See: Housing: Better Than Stocks In '08]

So what gives? Merrill says:

1. Either all the bad news has already been priced in.

2. Either the market is being driven by seasonals, market positioning and technicals. After all, we know that short interest on the Big Board plunged more than 3% in the second half of December.

3. Or a third explanation is that for every bad economic data point, there is added pressure on the Obama economics team to do even more when it comes time for the big fiscal reflation package. In other words, the market may be focused less on the patient right now and more on the cure. This, in turn, means that the doctors better come up with something that is going to turn the economy around. When you look at the consensus of GDP forecasts, and the timing of the market bottom back on November 20th, the expectation at this point is that the recession ends in the second quarter of this year.

Unfortunately, investors may have gotten a bit ahead of themselves. Basically, Wall Street is betting on an infrastructure and stimulus plan to fulfill some of the more optimistic hopes for a recovery in corporate profits and consumer spending.

Whether they get it will determine whether modest year-end bullishness is fantasy or reality. (Merrill says such bullishness really is being based on stimulus expectations, and that means heightened risks for stocks if the plan disappoints: Infrastructure shares are leading the rally, possibly due to some expectations that government spending will help right away rather than Merrill's 2010 timeframe for economy altering projects to finally make a dent. That could leave an uncomfortable and uncertain gap for stocks at a time when it's still not clear that stimulus plans of any expected size will be big enough to offset the rest of the economy's problems).

[See 5 Stocks Obama Could Boost]

So Merrill cautions:

To reiterate, we have enjoyed a big rally in the past six weeks that seems to be discounting a very quick end to the economic contraction with the arrival of the new Administration with all of its political capital. We are left wondering what the market reaction will be when it becomes clearer that the recovery will require a lot more time.

Other analysts touched on the "bad news bounce" theme too. In a slightly more upbeat mood, Jeff Saut of Raymond James sees a few reasons to be optimistic simply because lots of the damage is done. He writes:

Plainly, we agree and have opined that the time to be cautious was at this time last year, not after a 52% decline in the S&P 500. Indeed, just like participants were conditioned in 1999/2000 that declines would not gain much traction, participants have now become conditioned to believe rallies will not gain much traction. We don’t believe it and would ask investors to consider what could actually go right in 2009. To be sure, the equity markets are now well off of their respective November “lows.” Risk appetites are returning. Policy “easings” have accelerated almost everywhere. The U.S. dollar rally has abated. And, China has taken measures to keep its economy from slipping further into the abyss.

He's still worried about all those bad mortgage-related assets coming due this year, but says (bold is mine):

Yet, for the past few months the equity market has shown an amazing resilience to bad news, a trait we hope extends in the new year. Ladies and gentlemen, when markets turn a deaf ear to bad news that’s good news!

Comments

[CautiousInv...:]

I personally think there is much #3 in recent market activity.

What is interesting, though, is we only have the broadest idea of what the program will comprise and no assurance it will work. And even if it should, there will be lag times between approval and spending and we could be into 2010 before effects are felt.

I have grave reservations about government initiatives, particularly where large sums of money are involved. And I dont think the market appreciates that the Obama team will have to put up a vigorous fight to prevent congress from subverting national interests by attempting to direct spending to their states and pet projects.

Jan 06 06:37 AM

[OldLimey:]

Imagine you're in a Flying Fortress returning from a raid. Flak all around, and a shell takes out an engine. Scary stuff. Strap on the 'chute. But the old girl (B-17s are always female) struggles on and sighs of relief are breathed all around. Another shell hits and takes out a second engine. Seriously scary, end of the world sort of stuff. Head for the exits and prey hard. But again, those guys in Seattle know how to put an airplane together and she keeps flying. There's more flak, some passes by a Focke-Wolfe or two; bullets and shrapnel hit the fuselage, but it's not like losing another engine and the shock of each strike is a little less than the previous hit. Sure, a crewmate or two gets wounded - may even die, but first aid keeps them alive for now and hey, at least it ain't you. Then a smooth, calming voice comes from the control tower at base. The worst is over. No crash after all.

It's human nature - a coping mechanism - that we've been seeing (doubtless with a little source added by vested interests). Sooner or later reality hits home.

Jan 06 10:59 AM

[Brad Castro:]

Love Jeffrey Saut - he's usually right on. As I recall, he essentially called the November bottom (he may have been off by a day or two). When he says something, I pay attention.

OldLimey - great analogy, although I think I may have some shrapnel lodged in my backside.

Jan 06 01:35 PM

[sether:]

So, to sum up, no one really knows why the market really loves all of this horrible data. You all must be avid Professional Wrestling fans. The DOW should be at about 6000 right now. Go to your handy ^DJI chart, expand the timeframe to "max", and look at the curve (and make sure the chart is set to linear scale). Or look at the approximation of a cross-section of the great plains abutting the Rocky Mountains. The last 11 years were a joke. A fraud.

Jan 06 07:05 PM