A Medium Rare Market

Story Highlights:

• The stock market has rallied over the last two months in the face of negative economic news.
• Stocks react to what investors expect to happen in the future relative to previous expectations.
• Although recent economic data hasn't been rosy, it's become increasingly clear economic Armageddon isn't at hand.
• Whether the market has definitively entered a new bull or there's more volatility ahead, a market recovery will undoubtedly begin before all is clear on the economic front.

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Friday capped off another positive week for US and global stocks with the S&P 500 rising 2.4% and the MSCI World gaining 2.1% on the day and 6.0% and 7.1%, respectively, for the week. The stock market rally from the March 9th low has been nothing short of stupendous. Since its nadir, US and global stocks have climbed about 40%. Given those exceptionally strong returns, you'd expect the financial news to be littered with resoundingly positive headlines. But if you look at the news over the last two months, it's hard to find much to get excited about. Economies around the world are contracting, jobs are being lost, banks are being ordered to raise more capital—all seemingly bad. Although there are positives occurring all the time, they mostly go unnoticed and negative stories receive the lion's share of attention. Yet as bad as things have reportedly been, they haven't been nearly as bad as overly dour investors expected, and the stock market has reacted positively.

Investors expected the economy to produce the culinary equivalent of dog food, but they got hamburger, which tasted like a juicy t-bone steak compared to expectations. Put differently, the stock market doesn't react to what has happened. It reacts to what investors expect to happen in the future relative to previous expectations. The nearly 57% drop in the S&P 500 from October 9, 2007 to March 9, 2009 reflected a collective exceptionally dour view of the future. Talk of an impending repeat of the Great Depression was far more prevalent earlier this year than any notion of an economic recovery. So even though recent data hasn't been glowing, signs economic Armageddon isn't at hand have emerged and spurred a wave of stock buying.

For instance, first quarter US GDP was severely negative, falling at an annualized pace of -6.3%—the worst quarterly result since March 1982. Yet US stocks rose 2.2% the day of the announcement. Why? The few glimmers of positive news in the report glimmered more brightly than expected. Stress tests revealed banks need to raise tens of billions of dollars, but investors were encouraged to learn the banking system isn't insolvent as many claim. Stocks (bank stock especially) surged on the results. This Friday, it was reported 539,000 US jobs were lost in April. Investors cheered the fact it wasn't more, and stocks rose markedly.

Pundits claiming a market rally can't last because the economy is in the doldrums simply don't understand how the market functions. By the time the economy is being seated for dinner, the stock market will be enjoying the main course. And stocks have been priced as if Dog Chow will be on the menu for the foreseeable future, so even a hint of ground round sends investors clamoring for more.