Stocks: How 'Bad News Is Good News' Is Very Bad News

by: Eric Parnell, CFA

"Good news is good news and bad news is good news" is a refrain that we have consistently heard over the last several years since the quelling of the financial crisis in 2009. Such an investment climate has been terrific for equity investors in the time since, as stocks have shown the ability to rise both on any good news pointing to economic and market improvement and bad news that reinforces the need of the U.S. Federal Reserve to continue providing monetary policy support. Unfortunately, a market that has benefited from such conditions, particularly one like today that has benefited for so long, is that it suffers from the one very basic and terminal flaw, which is that someday in the future bad news will once again represent bad news. And it is even possible at some point that good news may also be considered bad news. We are potentially transitioning to such an environment at any time in the months ahead, and the associated fallout for stocks could be severe.

Here is the problem in a nutshell with the "bad news is good news" theme supporting the market. Bad news is not actually good news from a fundamental perspective. Instead, bad news is bad news, hence why it is referred to as bad news. So when stocks respond positively to bad news, it represents a mispricing of assets away from what would otherwise be their equilibrium price. And the more stocks rise over time on bad news, the more this mispricing is compounded. So the fact that stocks have been rising almost continuously for over four years in a "good is good and bad is good" environment implies that stocks are now priced beyond all recognition from what underlying fundamentals would have otherwise dictated.

Now the instinctive counterargument to this idea of mispricing is that stocks are actually rising for a reason when faced with bad news. After all, every time a bad piece of economic or corporate news hits the wires, it presumably causes the Fed to be more inclined to continue if not increase the injection of monetary stimulus into the financial system, which is widely known to have the effect of inflating stock prices.

The idea that the Fed is supporting stocks is essentially true, but this conclusion faces a few key dilemmas looking forward. First, the Fed is not going to continue to stimulate the economy forever. At some point, this stimulus will stop. And according to former Fed Chairman Alan Greenspan during a CNBC interview on Friday morning, he would be beginning this process right now if he were in charge. One wonders how much he has the ear of Mr. Bernanke. Also, once it becomes apparent that the Fed has begun the process of stepping away, stocks may react very swiftly to the loss of the key element that has transformed bad news into good news for so many years now, particularly now that the high frequency trading computers are now effectively in charge. And if recent history is any guide, the two brief instances when financial markets were left to go without any QE/Twist/LTRO stimulus or the promise that such support would soon be on its way, stocks moved swiftly and sharply lower by as much as -15% to -20% in a matter of weeks.

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Stocks do have the ability to overcome the mispricing that has resulted from the "bad news is good news" theme over the last several years. The one key fundamental outcome that would enable stocks to hold the gains they have generated over the last several years during this price distorting environment is if the pace of economic growth were to accelerate to the point that it could fill in the artificial gap that currently exists underneath stock prices.

Economic growth remains woefully insufficient to support stock prices at these levels without the support of Fed stimulus, however. Overall growth has not accelerated coming out of the financial crisis. Instead, it has become increasingly sluggish in the U.S. over the last two years and has already slowed dramatically if not fallen into recession across many other major global economies. Thus, broad economic growth is not likely to even come close to filling the gap. In fact, it may increase the void in the end.

Corporate conditions are also becoming increasingly inadequate to sustain the current air pocket beneath stocks. In the first few years following the outbreak of the financial crisis, the rise in stock prices was at least being supported by a commensurate rise in earnings. But this relationship has deviated widely over the past year. For while corporate earnings growth has effectively ground to a halt, stock prices have continued to rise. Thus, the gains in stocks since early 2012 have come almost entirely as a result of multiple expansion, as the stock market price-to-earnings ratio based on S&P 500 (NYSEARCA:SPY) as reported earnings has increased from just below 14.5 times at the beginning of last year to over 19.0 times today.

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Of course, stock prices are driven by forward looking expectations, so it could be argued that this multiple expansion will be justified by the realization of higher earnings expectations going forward. Perhaps, but such an optimistic outcome will be difficult to attain amid a continued global economic slowdown and corporate revenue growth that has stalled at less than +2% over the last several quarters. Moreover, S&P 500 earnings estimates for both the second quarter as well as for the 2013 calendar year have been chronically declining for well over a year at the same time that stock prices have been rising. And it could easily be argued that even with these downward revisions that expectations for 12% to 13% earnings growth for the 2013 and 2014 calendar years may still be far too optimistic given the effectively flat rates of annual earnings growth that have been recorded since last summer. Thus, it would be a dramatic stretch for corporations to even begin filling the "bad news is good news" void currently underneath stocks.

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The fact that the market has become so vastly mispriced over the last several years by this "bad news is good news" perspective is very bad news for investors once the crutch of Fed policy stimulus that enabled bad news to be good news is finally taken way. And this threatens to bring havoc to stock portfolios for a variety of reasons. The following are just a few of the key questions that are becoming increasingly difficult to answer with each passing year under the influence of QE and other aggressively easy monetary policy programs.

First, how much of today's economic growth can be directly or indirectly attributable to policy stimulus from the U.S. Federal Reserve? Is the only reason we have positive economic growth right now due to the volume of stimulus currently being injected into the U.S. economy? Is the economy stronger than that? Or perhaps it's much weaker than imagined?

Also, what percentage of today's corporate revenues and earnings can be directly or indirectly attributable to Fed stimulus? In other words, how much lower would revenues and earnings be without the steady flow of Fed stimulus over the last four years?

Lastly, what price-to-earnings multiple will the market assign to stocks once Fed stimulus is reduced or removed? Will investors still be willing to pay more than 19 times as reported earnings on the S&P 500 when a critical source of confidence in rising stock prices is removed? If not, how much less? 15 times? 12 times? Even less?

The fact that we have been under the steady influence of Fed stimulus over the last four years since early 2009 has so vastly distorted all of these measures and has made attempting to answer these questions increasingly uncertain with the passage of time. And if there is one thing above all else that financial markets including stocks do not like is uncertainty.

All of this implies that we are likely to find ourselves some day soon facing a day of reckoning when bad news is no longer good news and in fact is actually regarded as bad news. Moreover, the fact that prices have been so wildly distorted under the notion that both good and bad news is good news over the last four years is likely to lead to an extended period of give back where good news is at a minimum ignored and at worst also perceived as bad news. For example, one could easily envision a scenario in the not to distant future where good economic news is viewed as bad news because it implies that the Fed may need to tighten sooner than expected. Yang has an uncanny way of balancing with yin over time.

In the meantime, current Fed policy measures remain intact and the market continues to respond accordingly. How long is another question, for it could end as soon as the next FOMC member steps to a podium, but such is in the environment that is still in place today. As a result, it remains reasonable to maintain an allocation to stocks, but the emphasis should increasingly be focused on those categories or individual names that exhibit the characteristics of high quality, attractive valuations and relatively lower price volatility and favorable technicals that can continue to participate in the stock market rise but can also hold up relatively better during a swift market decline. Representative names include Exxon Mobil (NYSE:XOM), IBM (NYSE:IBM), General Electric (NYSE:GE), McDonald's (NYSE:MCD), Emerson Electric (NYSE:EMR), Qualcomm (NASDAQ:QCOM), Cisco Systems (NASDAQ:CSCO), Comcast (NASDAQ:CMCSA) and AT&T (NYSE:T). While all are ideal long-term holdings, each should be viewed with a relatively short time horizon and a close eye on technicals in the event that a swift market sell-off on tapering fears, Japanese bond market volatility or anything else unexpected appears imminent.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

Disclosure: I am long CSCO, GE, T, XOM, MCD, CMCSA, IBM, QCOM, ORCL, EMR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.