If Things Are So Bad, Why Won’t the Stock Market Break?

One of the things that confounds many people is the value of the stock market. If the economy is so bad, and it is, why doesn’t the stock market take a dive and stay there? If the stock market were going to a psychiatrist, the bills would be higher than our national debt because there is no way you can figure it out with certainty.

SPY data by YCharts

There are a lot of reasons for not being able to figure out the buoyancy of today’s market given all the worldwide strife.

First, the stock market isn’t necessarily a reading on how things are today. The stock market price takes into account ALL information that is publicly available. As simple humans, we concentrate on a few pieces of information and expect an outcome-filtered by our own personal biases. The market doesn’t do that. It prices in everything.

That means the market may be pricing in a lot of potential future gains. For example, we know that in three economies, Brazil, China, and India, there is a lot of room for growth. Certainly American companies will benefit from that massive growth. But, we don’t know when or at what pace that growth will happen. Some money has found it’s way into the market betting on that growth because it has a time horizon of much longer than the average investor. Efficient Market Theory works.

Second, the actions of the Federal Reserve have changed investing incentives. By pursuing a policy that artificially downgrades the value of the US dollar, investors are forced to change their preferences for investment. Because the expectation of the dollar value is decreasing, investors are taking more risk with their money to seek return. Looking at the choices, bonds or stocks, the better chance of making money grow is in the stock market.

Third is the nature of markets. There is still a lot of cash on the sidelines waiting for the big break that never seems to come. As the market trickles up, pressure starts to weigh on that cash. The Fed devalued, but the investor hanging on is unwilling to take risk. Eventually, that dam breaks and cash will flood into the market driving it higher.

One thing traders learn early. If everyone is the same way in the market, the market will definitely go the opposite way until the pain is so bad people cover. Once they cover their position, it will go the way everyone initially thought it would go.

Look at the NASDAQ in 1999.

QQQ data by YCharts

For years, most investors stayed out of the market. From 1995 on, the common refrain was, “these internet companies make no profit, how can buckets of money get thrown at them?”. Finally, in January of 2000, the Fed lowered rates and capitulation happened. The market set a high and then crashed. We may be nearing that point again.

SPY data by YCharts

If we get an Obama victory, the market will stage a short term rally. It’s not celebrating. Markets never celebrate or mourn, they just exist. It’s an indication of certainty. Obama will have some breathing room to unentangle the US from the coming fiscal cliff. If he doesn’t do it, or it’s perceived as an adverse method of untangling, look out below. From everything that we know, Obama’s method will be higher taxes and higher spending. Unless he doesn’t control Congress. Then it’s a fight.

If we get a Romney victory, the market will also rally. Then he gets to deal with the fiscal cliff. It looks like he would also control both houses of Congress. The solution will be lower taxes and less spending. My guess is the market would have a sustained rally off that solution-but your guess is as good as mine. It’s what makes a market.

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