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: