Stocks are rallying, portfolios are recovering, and the financial news is rosy. This seems to be the perfect recipe for more profits coming our way. The only fly in the ointment is that exactly this combination of events usually foreshadows lower prices, perhaps even another meltdown. Here’s what the recent news REALLY means.
We learn something new every day and often it turns out that what we learned the day before was incorrect. It’s easy to get caught up in the moment and take – what we presume to be facts – at face value, even though it might be nothing more than hot air.
The spring rally in stocks has awakened a spring-like feeling of euphoria not seen for over a year. Obama’s budget chief thinks that the economy has almost bottomed out; Goldman Sachs, JP Morgan, and Morgan Stanley have applied to repay bailout funds; the Wall Street Journal reports that stocks rise as recovery hope builds; and Warren Buffett doubles down on derivatives while betting on America.
The meaning of news – in a bull market
Most investors tend to follow the allure of good news, trusting that positive reports will result in higher prices, while only a few bother to second-guess the prevailing atmosphere. It’s important to note that news reports need to be interpreted in context with the market’s overriding trends.
During an extended bull market, good news often results in higher prices. We experienced this first hand in the late 90s, and once again from 2002 to 2007. Back then, good news did result in higher prices. Subsequently, news reports became even more upbeat which drove prices even higher. Expectations were thus justified by the very action that sent prices up.
The meaning of news – in a bear market
Once a bull market reverses, it takes a while for bad news to catch up with lower prices. Up until last October, investors in large were still positive on the market. Why? Denial was the overriding factor. A 20+ year booming economy has conditioned us to believe that prices will go up indefinitely and pullbacks are the best buying opportunities.
Even Warren Buffett stepped into the trap and “bought America” in October 2008. On December 16th, Morningstar reported that the Dow is selling at a 30% discount, while TheStreet.com pronounced the stock sale of century. Despite the alleged discount stocks were selling for, the S&P 500 (NYSEArca: IVV) went on to lose about 30%.
A bear market tends to bottom, at least temporarily, when the media portrays a doomsday-like atmosphere. Do you remember the avalanche of bad news hitting the wires about two months ago? Incidentally, that’s when the market bottomed. On March 9th, the day the market bottomed, the Wall Street Journal featured the following article: “Dow 5,000? There’s a case for it.”
Once again, the good news is now lagging behind rising prices. Eventually it will catch up, if it hasn’t already. Towards the top of a bear market counter move, the amount of positive news culminates in a composite feeling of optimism. Just like a wave reaches the highest point just before it breaks, investor sentiment reaches a crescendo just before the market tops.