Earnings could tip the scale

The US stock market has been on shaky ground this year. A variety of economic numbers across the globe have shown slowing growth across geographic regions. And yet markets are still near all-time highs….Why? Bad news should be bad news, right? Good news is good news…right? Wrong. We are currently (and I emphasize “currently”) in a “bad news is good news” market dynamic.

Over the past 30 years, the Federal Reserve has raised or lowered interest rates to moderate our economy. This active monetary policy is meant to soften economic cycles and for the most part it has worked pretty well. Ironically, in the last 20 years, we have had two of the largest declines in stock market history, the Internet Crash and the Great Recession. In those circumstances, changes in interest rates could not prevent the declines, they could only help stimulate the recovery.

Still, the Federal Reserve’s actions (rates to zero, QE, etc.) during the financial crisis 10 years ago has elevated their status in the minds of institutional investors. Basically, investors now automatically assume that if the Fed begins to intervene with some sort of stimulus measure, like lowering interest rates, everything will be fixed and the market will go higher, i.e. bad news is good news! We all know what happens when we make assumptions. In 2007, investors assumed housing prices couldn’t go down, they assumed credit agencies were doing reasonable due diligence, etc.

UBS had a great chart out this morning on Bloomberg addressing the “bad news is good news” dynamic. They suggested that if earnings growth breaks below zero, this could change the dynamic. The Fed has made a dramatic shift in sentiment since the beginning of the year and yet earnings growth continues to decline. You can still say, “Well, it’s not great but at least it is positive…” , at least for the moment.

I agree that if earnings continue a downward slide and break the zero bound, investor confidence in the Fed’s ability to avoid a recession could break. There are many, many other factors investors could cite to justify selling. My working contention is that we are entering into a new regime where the tools we have relied on in the past may not work in the future. Japan has been dealing with it, Europe has been infected, and the U.S. could be next.

earnings markets S&P500 stocks economy Fed interest rates