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Is Good News Still Good For Stocks?

Daily State of the Markets
Monday, January 7, 2013

Good Morning.

Good Morning. Now that the immediate issues of the fiscal cliff have been resolved - meaning that Congress did (finally) manage to agree that (a) enacting what would have been the largest tax hike in history wasn't a good idea and (b) they would need to have further discussions on the topics of the budget deficit, the debt ceiling, and reforms to the tax code and entitlements - the market appears to have breathed a huge sigh of relief. Getting the first part of the cliff deal done was good for a quick joyride to the upside to the tune of 500 Dow points and/or about 4.5% on the S&P 500.

While this is clearly "old news" by now, it is important to remember that in the stock market it's not the news itself that matters, but rather how the market reacts to the news. So, given that the S&P 500 closed Friday at a fresh 5-year high and that both the midcap and smallcap indices jumped to new all-time highs, it is safe to say that avoiding a self-inflicted recession was viewed as a positive.

However, the bear camp can argue that the blast higher was due primarily to short-covering, algo-induced trend hopping, and the state of the calendar (recall that the last 7 trading days of a year as well as the first week of a New Year are traditionally strong due to fund flows and asset allocation). Our furry friends suggest that the current macro environment isn't that great and that the current rally is likely to peter out in short order.

On the other sideline, the bulls can be heard outwardly scoffing at their opponent's assertions. Those seeing the glass as at least half full point to a growing economy, low inflation, low interest rates, decent valuations, and an overvalued bond market as big-picture reasons to be long stocks at the present time. And in response to the argument that earnings are slowing, those in the bull camp are quick to remind us that stocks look forward, not back. As such, as long as the economy can improve, then stocks can advance this year.

To be sure, we got a fair amount of good news over the past week. In addition to the fiscal cliff decision, the bulls were treated to better than expected reports from ADP on private sector job growth, the ISM Non-Manufacturing Index (indicating that the service sector of the economy continues to expand), and Nonfarm Payrolls. While the jobs report wasn't that exciting from a headline perspective, the internals of the report weren't bad at all. This suggests to some that the uncertainty surrounding the fiscal cliff may have been unwarranted and that the economic glass remains half full at this stage.

The Next Problem?

However, stocks sold off hard on Thursday afternoon following the release of the minutes from the latest FOMC meeting. Traders (and their computers) were surprised to read headlines suggesting that a growing number of FOMC members feel that the current QE program could end sooner rather than later. While Mr. Bernanke's gang has made it abundantly clear that rates will stay low and QE will continue until the economy improves, it appeared that the "fast money" decided this was a game changer.

The fear is that the Fed is going to pull the QE punch bowl and remove one of the primary tenets to the bull argument in the process. As such, we instantly began to consider that good economic news might start to become bad news for stock prices again.

On Friday, the algos appeared to implement the "good news is bad news" trade after the ISM Non-Manufacturing Index came in well above expectations. The S&P instantly dove 4 points on the news and for a moment, it looked like the game had changed. However, stocks quickly found their footing and buyers emerged, pushing the indices higher into the close.

While the action in the stock market would seem to suggest that good news is still good news, we do need to take note of the recent action in the bond market. The yield on the U.S. 10-year spiked up hard last week, moving from a low of 1.694% to 1.915% at the close. And while rising bond yields haven't been a concern to the stock market for many years now, experienced investors know that higher rates can impact stocks - and not in a good way.

However, in my humble opinion, we aren't there yet. Everybody knows that yields have been kept artificially low for an inordinate length of time as the Fed has done everything it can think of to try and get the economy moving. So, if (a big if) the Fed were to decide that it can indeed start to step away from its stimulus efforts, it would be due to the fact that the economy is improving. And since rates would still be quite low from an historic perspective even after such an event, my guess is that stocks won't worry too much about a move up in rates from a big-picture perspective.

But, given that stocks are overbought and flirting with new bull market highs; this does not mean that traders won't be able to use a further spike in rates, the fear of the Fed pulling the punch bowl early, or a continued pullback in earnings growth as reasons to sell for a while. Almost anything can cause a near-term pullback in this type of environment. But unless things change, we would view such a pullback as an opportunity to add to long-term positions. Again, unless things change, it is our belief that good news remains good news from a big-picture perspective.

Turning to this morning... Things are fairly quiet in the early going on this Monday morning. The battle for the budget continues unabated with both sides apparently digging in for a long, hard fight. Traders will be eyeing the start of the Q4 earnings parade, which kicks off tomorrow with releases from Alcoa (NYSE:AA) and Monsanto (NYSE:MON). The focal points of the upcoming earnings reports will be the impact of the fiscal cliff debate and the outlook for the coming quarter/calendar year.

On the Economic front... There are no reports scheduled for release today.

Thought for the day... Have a great Friday and enjoy your weekend.

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

Major Foreign Markets:
- Shanghai: +0.37%
- Hong Kong: -0.01%
- Japan: -0.83%
- France: -0.56%
- Germany: -0.31%
- Italy: -0.19%
- Spain: -0.13%
- London: -0.31%

Crude Oil Futures: -$0.54 to $92.55

Gold: +$7.10 to $1656.00

Dollar: higher against the yen, euro and pound

10-Year Bond Yield: Currently trading at 1.904%

Stock Futures Ahead of Open in U.S. (relative to fair value):
- S&P 500: -4.67
- Dow Jones Industrial Average: -32
- NASDAQ Composite: -8.19

Positions in stocks mentioned: none

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