It’s Tuesday October 22 and the delayed September employment announcement shows disappointing progress on hiring — bad news for the economy and for stocks, right? Well, if the valuation of the stock market had anything to do with the real economy, you would be right, this report should have been bad news for stock prices as well. But stocks ended the day up over half a percent.
It turns out that markets now think that bad news for the economy is good news for the stock market. This is paranormal market activity.
What’s going on here?
Bad news is good news for stocks as it implies a longer period of Fed accommodation, which has been propping up risk asset prices. This behavior illustrates the overwhelming market consensus: the economy is too weak and too dependent on “financial market conditions” to consider a pullback in quantitative easing —the Fed’s bond-buying program, let alone an abandonment of zero interest rates.
Here’s how the Fed policies benefit stocks and other risk assets:
- They create more money in the financial system that has the effect of pushing up financial asset prices.
- It reinforces the idea that the Fed will continue to hold interest rates at zero, which compels investors to seek out higher (than zero) returns.
- The increase in the demand for risky assets (as opposed to government bond assets or cash) pushes up the value of risky assets, of which stocks and fixed income credit such as high yield and bank loans, are prime beneficiaries.
Here’s what this paranormal activity looks like in the market—when better-than-expected economic news hits, stocks drop and vice versa:
How long will paranormal activity continue?
Likely until investors finally get clarity around when the Fed will act. If the Fed can convince markets that short-term interest rates won’t spike again like in May-July of this year, then the next taper conversation may be less bumpy for markets. That, however is a big ‘if,’ and the Fed may not be able to orchestrate such an outcome. While we expect tapering of the Fed’s bond-buying program to be deferred into next year, the possibility of the Fed moving sooner than markets expect represents a key risk to the short-term outlook.
What does this mean for investors?
Given the market consensus that the economy isn’t healthy enough to advance without accommodative Fed policies, we now see greater downside than upside to the risky segments of fixed income (high yield bonds, bank loans and securitized assets). While longer term we continue to view these asset classes favorably, our downgrade to “neutral” from “overweight” reflects their diminished risk/reward tradeoff over the next one- to three-months.