The market hates uncertainty. Sometimes stocks will actually rally after bad news breaks – for example when a big lawsuit is settled or a new regulation is passed that will result in a decrease in sales. While this may seem counterintuitive, the reason is that once the news comes out, the uncertainty is lifted.
Today we saw evidence of this in the market rally. The Dow Jones Industrials – a common measure of the health of the market – rallied more than 200 points. Of course, a rally of 200 points with the index at 11000 doesn’t mean the same thing that it did when the index was at 2000, but it was still an impressive move. This rally was caused by two factors: 1)the monetary policy of the Federal Reserve and 2) a resolution of uncertainty in the regulatory environment in general and cap-and-trade in particular with the election of a mostly Republican House.
On the first factor, the Federal reserve indicated that they will continue to buy long-term bonds in an effort to reduce long-term interest rates. They are hoping that by lowering borrowing costs, more people will borrow money and do productive things with it that will stimulate the economy. This can have the desired effect, but also has the effect of weakening the dollar, which can lead to inflation and currency wars with other countries – neither of which is a good thing for the economy. Like pouring gasoline on a fire, however, lowering interest rates does normally cause economic activity to increase at least initially, so moves by the Fed to lower interest rates will generally cause a stock market rally. Hence the old Wall Street axiom, “Don’t fight the Fed.”
The second factor is a lifting of the uncertainty. Before the Republican takeover of the House of Representatives, the Democratic party was able to pass many measures that affected corporate profits at will. Health care reform, the pay czar, choosing of winners and losers in the auto and banking industry, and the new financial regulatory measures all caused uncertainty because they made it difficult to predict future earnings for companies. The possible passage of cap-and-trade, which represented a huge new tax on productivity, also cast a cloud of uncertainty over the markets.
Under such regulatory environments, one may expect a company to do well, only to have the Government pass a new law that causes profits to fall. Predicting whether a company succeeds or fails becomes less about the fundamentals and more about reading the political tea leaves correctly. Because this makes it very difficult to predict future returns, and thereby determine fair price for a stock, investors are leery to put their money into the market. They instead take a wait-and-see attitude which causes the market to falter, or demand a lower price for stocks to reduce their risk of paying too much. Add the possible inflationary environment caused by the Fed, and you also get a big run-up in gold and other commodity prices (witness the record highs in gold prices).
With much of the uncertainty lifted, I would expect to see a rally in the market. Conversely, the price of gold will likely fall, perhaps precipitously, as the current bubble bursts. This will hold true unless the actions by the Feds do result in an increase in inflation. I do not expect a rapid recovery in the real economy, however, since many of the factors affecting job growth (rises in health care costs, increases in regulation, laws increasing the cost of labor) remain in place. This may keep inflation in check.
As always, the strategy is to invest money that won’t be needed for several years in the stock market in long-term growth stocks and to move money that will be needed into short-term instruments such as CDs. Also, proper diversification should be maintained with no more in any one investment than one would be willing to lose.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.