What It Means When Stocks Rally On Bad News

It didn't happen today when those terrible auto sales hit, but all through December and into the New Year bad economic reports actually sparked almost all of the Dow's recent rally from November lows.

In fact, all the Dow's gains since November 20 came on just six trading days when depressing data (sinking home prices, a dismal employment report, a terrible ISM manufacturing number) sent stocks up by triple digits. That's according to Merrill Lynch economists who find it "absolutely fascinating that since equities bottomed on November 20th, the Dow has managed to rack up 1,482 rally points. And, they all managed to come on days when the data could hardly have been worse."

[See: Housing: Better Than Stocks In '08]

So what gives? Merrill says:

1. Either all the bad news has already been priced in.

2. Either the market is being driven by seasonals, market positioning and technicals. After all, we know that short interest on the Big Board plunged more than 3% in the second half of December.

3. Or a third explanation is that for every bad economic data point, there is added pressure on the Obama economics team to do even more when it comes time for the big fiscal reflation package. In other words, the market may be focused less on the patient right now and more on the cure. This, in turn, means that the doctors better come up with something that is going to turn the economy around. When you look at the consensus of GDP forecasts, and the timing of the market bottom back on November 20th, the expectation at this point is that the recession ends in the second quarter of this year.

Unfortunately, investors may have gotten a bit ahead of themselves. Basically, Wall Street is betting on an infrastructure and stimulus plan to fulfill some of the more optimistic hopes for a recovery in corporate profits and consumer spending. Whether they get it will determine whether modest year-end bullishness is fantasy or reality. (Merrill says such bullishness really is being based on stimulus expectations, and that means heightened risks for stocks if the plan disappoints: Infrastructure shares are leading the rally, possibly due to some expectations that government spending will help right away rather than Merrill's 2010 timeframe for economy altering projects to finally make a dent. That could leave an uncomfortable and uncertain gap for stocks at a time when it's still not clear that stimulus plans of any expected size will be big enough to offset rest of the economy's problems).

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So Merrill cautions:

To reiterate, we have enjoyed a big rally in the past six weeks that seems to be discounting a very quick end to the economic contraction with the arrival of the new Administration with all of its political capital. We are left wondering what the market reaction will be when it becomes clearer that the recovery will require a lot more time.

Other analysts touched on the "bad news bounce" theme too. In a slightly more upbeat mood, Jeff Saut of Raymond James sees a few reasons to be optimistic simply because lots of the damage is done. He writes:

Plainly, we agree and have opined that the time to be cautious was at this time last year, not after a 52% decline in the S&P 500. Indeed, just like participants were conditioned in 1999/2000 that declines would not gain much traction, participants have now become conditioned to believe rallies will not gain much traction. We don’t believe it and would ask investors to consider what could actually go right in 2009. To be sure, the equity markets are now well off of their respective November “lows.” Risk appetites are returning. Policy “easings” have accelerated almost everywhere. The U.S. dollar rally has abated. And, China has taken measures to keep its economy from slipping further into the abyss.

He's still worried about all those bad mortgage-related assets coming due this year, but says (bold is mine):

Yet, for the past few months the equity market has shown an amazing resilience to bad news, a trait we hope extends in the new year. Ladies and gentlemen, when markets turn a deaf ear to bad news that’s good news!