Don’t Know What to Do with Bad News — or Good News Either

by Inya Ivkovic, MA

I don’t know what to make of the stock market recently and it seems that I’m not the only one. When news is bad, but not as bad as expected, the market rallies. When news is good, the market is lukewarm. I mean, after the financial and credit panic has wreaked its havoc, irrational behavior no longer surprises me, but I do find it quite irritating.

Recently, we have learned of improved housing sales, more durable goods orders, and increasing consumer confidence — and even the Fed’s chairman Bernanke is optimistic – and, yet, most of the major North American indices barely budged. Not so long ago, when employment figures or GDP numbers contracted by a fraction of a percent less than expected, the market would rally like there is no tomorrow. But now when things appear to be improving for real — nothing?! Could it be that the buying momentum is deflating? And just in time for another September from hell?

Since the March lows, the stock market has rallied approximately 50%. In a way, it makes perfect sense for investors to exploit one of the oldest investment clichés: buy on rumor, sell on fact. Considering some analysts’ calculations that the S&P 500, for example, is trading over 100% its trailing earnings, a good old selloff could definitely be in the cards.

But overvaluations might not be the only reason for potential selloffs. Investor sentiment could also be an impediment to more gains in the fall. The logic behind this postulate is frighteningly simple: if everyone is buying, then buyers abound and the pool of new buyers has been exhausted, leaving no one to carry on the upward momentum. And once buying momentum has been exhausted…well, you get the picture.

One reason why the market still appears so bullish are those stubborn bond prices, which are suspiciously high, and bond yields, which are ultra-low at the moment, the latter factor known to move in the opposite direction to overall market prices. The bond market refuses to sell off, short-covering is simply not happening, and bond yields are lingering around three percent, instead of matching Obama’s debt forecasts close to five percent. In other words, the bond market thinks that the equity market is wrong, but market behavior makes it difficult to discern who is right.

Even more worrisome is that the stock market has raced well ahead of the global economic recovery, and the next logical question is: will recovery pick up its pace to match and justify those exhilarating market gains? Some economist believe that lukewarm recovery is good for stocks, because it often means that the liquidity taps would be left running with interest rates that are historically low. Any more robust a recovery, and interest rates would have to go up, pushing prices down and putting a serious damper on the stock markets.

I’m inclined to believe that the bond market telling us the stock market is wrong is a sentiment that should be reckoned with. Additionally, the stock market has had its recovery, gaining back 50% since March lows, which is truly impressive, but now is the time not to get too ahead of itself and to allow for the rest of the economy to catch up. Otherwise, we’ll be facing another painful correction too soon and in too fragile a state, which could put the economic recovery far too many steps behind.