When Bad News Is Good News

fall tough people

The stock market is infamous for its counterintuitive nature.  It’s not uncommon for investors to be confused when a company misses earnings estimates and yet its stock rises.  Or for the news of economic strength to lead to stocks going down.  The answer lies in future expectations.  The stock market looks ahead at what to expect as reality several months down the road, not what is happening at the current moment.  This means news of the day is interpreted through the lens of what it might mean for what to expect next.  Said another way, a company’s stock price isn’t as much rewarded for a good quarter of earnings that just passed as much as it is punished for management giving weak guidance for what to expect next. 

This explains how bad news can often be good news in terms of how asset prices react.  I am mostly referring to stocks, but the same is true for bonds, real estate, commodities, and so on. 

We are in one of these phases in the stock market now.

The reason is that the biggest waves of fear in the markets are inflation and what the Federal Reserve might need to do with interest rates to combat it.  Simply stated, ever-rising interest rates that might be needed to tame inflation are poison to stock valuations. 

The mental struggle that comes with this is that the Federal Reserve must make, to some degree, an enemy out of further economic expansion, job creation, stock prices, wage increases, house price increases, and essentially, the appreciation of all assets.  By doing so, they tame inflation for the greater good over time.  This might be un-welcome and painful in the moment, but it is the most effective bad-tasting medicine for the bigger problem.  It’s well noted that inflation can snowball and destroy an economy, if not a nation itself.  For this reason, grimacing at the taste of the medicine is better than ignoring the potentially fatal ailment.

This means that bad economic data would be welcome to stock prices.  Counterintuitive, but true because that would mean the Federal Reserve is closer to the end of the rate hiking cycle than feared, thus allowing the market to anticipate better things on the horizon.

This brings hope to investors.  But hope is a double-edged sword.  I’ll come back to this notion a little later.

But let me first point out a few currently negative indicators that historically have acted as counterintuitive positives for asset prices. 

One is that we’ve begun to see home purchase contract cancellations skyrocket.  Would-be buyers are content to walk away from deposits rather than close on houses that have become more expensive through a combination of price appreciation and higher mortgage rates.  The result is a stop to overheating house prices, which becomes an ironic healthy positive.

Another positive is the recent spate of hedge fund collapses.  I’ve been in this industry for nearly 30 years now and I have never seen a bottom in a market without speculation being severely punished.  And, despite the misleading name of ‘hedge’ fund, the overwhelming majority of these pools of assets are pure speculation.  We’ve seen many funds get closed in recent weeks with their focus ranging from the crypto space to the commodity complex and even all the way to the ‘deep value’ space.  Their common denominator is always the same – leverage.  No matter where they focus their investments, they use loads of leverage in an attempt to make loads of speculative profits knowing that if they win, they keep the money; but if they lose, they just shut down the loosing fund worth pennies on the dollar and start over again.  If ever there was a place where the industry regulator watch dogs are letting down the public, this is it.  Hedge funds, not all, but overall, are a scourge in the investment world.

But I digress. 

Other ‘positive’ negative includes the result of the most recent CNBC investor sentiment survey that revealed the most bearish outlook for stocks among their respondents ever.  This includes the periods of the dot.com bust and the Great Recession.  This is corroborated by the highest ever bearishness reading from the AAII (American Association of Individual Investors) and their work goes back even further to include the crash of October 1987.  And before you think it’s just the average individual investor who is scared of their shadow, the professional ranks are skittish, too.  While not quite at the same historic all-time lows as the individual investor, State Street’s professional sentiment index is in the bottom quintile of confidence ever.  These are some serious counterintuitive positives if you use history as a guide.  Simply put, in the quarters that follow negative readings, stocks tend to do quite well, and vice versa. 

When you consider these data points and add to them the recent plunge in all commodity prices you might feel that sense of hope rushing in that perhaps the markets have seen their bottom.

But, in keeping with the use of the character Red from Shawshank Redemption of the last issue: “hope can kill a man”. 

Markets very rarely bottom when hope is alive.  Instead, markets bottom when there’s a sense of hopelessness and true capitulation.  Even with all the negative sentiment I referenced, it hasn’t shown in traditional ways in the market itself.  This is best seen in the VIX index.  This is an options driven volatility index that has become known as the ‘fear gauge’ for the market.  It hasn’t quite risen to levels that have marked bottoms in the past.  And while the market has suffered the occasional sloppy day in this bear market, for the most part it has been an orderly decline.  There hasn’t been that one real washout day that is also present with all prior market bottoms.  That’s the day when investors believe things will never get better and they just want to stop their pain immediately at any cost.  That cost, of course, is long term wealth creation.  But it’s that capitulation and loss of hope itself that usually marks a true market bottom.  We simply haven’t seen that type of day yet. 

Perspective is a much more valuable tool for investors than hope.  As I’ve mentioned before, perspective is best kept when there’s an accurate distinction between your savings money and your investment capital.  Specifically, any money that might be needed in 6-12 months isn’t investment capital and it shouldn’t be invested in the stock market.  Ever.  This period of market weakness isn’t an exception because times are currently tough; this is a forever and always rule, no matter what.  Among other things, it assures that the investments you have in the stock market are just that, investments.  The name itself implies an element of deferred gratification.  These are dollars you can let work for their highly probable benefit over time and not put at heightened risk for fear of needing to be lucky with market timing.  Being able to keep perspective means market volatility can be taken in stride rather than be a reason for lost sleep.  It means you can better recognize volatility as a normal course of action and even a source of excellent opportunity rather than merely the one-dimensional measure of risk.

Perspective greatly increases your chances of being in the market at the bottoms.  Not that those bottoms are fun times to be invested.  But truly un-fun times are when you are scrambling to get back into the markets as they rally higher and you become afraid to pull the trigger for fear of having your timing wrong.  Being invested at the bottom also means you’re invested at the beginning of the recovery, which is very profitable.

You see, there’s a common misperception that stocks perform their best when economic times are good and investor confidence is high.  As I’ve intimated before, that’s not at all true.  Stock do just fine when the landscape improves from good to great.  But by far and away, stocks perform their best when things go from bad to less bad.  That’s when the markets bottom and move back higher, which they have a habit of doing quickly and unexpectedly. 

It’s my sense that we’re close to this important inflection point.  While I think we’re nearing this point, I can’t say I have a high degree of confidence that we’ve actually gotten there.  Where I do have confidence is that asset prices will be appreciably higher in a year’s time.  That’s where perspective comes in.  Just how important is it to know if or when the bottom has been hit?  If your time horizon isn’t a handful of months, these are good times to be an investor.

Consider this data from Ritholtz Wealth Management: markets are never down three years after a recession.  As I mentioned in the last issue, I don’t much care for specific definitions of things like recessions or bear markets since they can be ambiguous in many ways.  Be that as it may, a lot of historical metrics revolve around the starts and ends of classically defined things like these, so we must take it with a grain of salt.  And as it relates to these data points from Ritholtz, we would all be cheerleading for the label of recession to be given quickly.  That’s because they continue their work to say “we studied every post-World War II recession, and the effects on the stock market before, during and after.  And do you know how many times three years after a recession has been officially declared, the stock market has been down?  Zero times.  It has never happened.  What’s more, stocks posted a triple-digit return after five years in every single instance”.  Boy, given those stats, who would sell stocks in a recession?  And wouldn’t we hope that we’re in one now?  What other asset is highly likely to be not just positive, but substantially so three to five years down the road?

But good advice in all things is to remember that hope is not a strategy.  A real strategy revolves around knowing that finding tops and bottoms in any asset price is impossible.  A sound strategy doesn’t rely on market timing.  It instead leans on perspective.  That’s what creates the ability to endure bad market patches and even thrive on their other side because you were able to accumulate high quality assets at lower prices either through dividend reinvestment or through systematic deposits. 

When we remember that times like these ultimately do pass and then consider the value that can be created throughout the painful periods, we can shift our mindset to at least endure and recover.  Or, if we’re in the financial position to do so, think opportunistically about how these periods are great times to buy what we know might not show a profit right out of the gate, but that we know will be of great benefit in the years to come.

The Takeaways:

  • Lots of economic, statistical, and emotional data have begun to show signs of hope that the worst is behind us.  But hope alone isn’t a cure.  Each of us should always monitor our financial well-being and overall allocations to be sure we only have true investment capital in the markets and not any money we might need to use in short order.
  • The market’s volatility isn’t likely over, but encouraging signs abound.  One final research piece specific to the topic of current market volatility comes from Jason Goepfert and his SentimentTrader service.  His work stated that “market volatility over the past 5 weeks is at the highest level since 1928, causing a lot of negative sentiment.  Over the past 80 years, similar instability coincided with the ends of bear markets”.
  • The Federal Reserve is hard at work trying to find the most appropriate monetary policy for the current economy, and they are certain to continue raising rates.  As they do so, my economically inclined readers here should be very happy to hear that the M2 money supply has been plunging recently and better news would be hard to find.  In simple terms, this means the printing press has been slowed down in terms of new money creation, which is of vital significance in the fight against inflation.
  • It is my personal view that while stock prices may not have yet found their bottom for this phase, they are likely to be comfortably higher in a year’s time.  And perhaps much higher looking out more like 3 to 5 years.  With that perspective in mind, we take solace in knowing that tough times don’t last, and they do indeed usher in future growth.


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