Bad News Pushes Stocks…Higher?

Investors seem to think that a slowing economy will somehow give way to a boom next year.

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The stock market often has a mind of its own, heading in a direction that seems contrary to conventional wisdom. Now is one of those times.

[Slideshow: Obama's crackdown on corporate America]

The last two months have been a parade of bad economic news. The European financial crisis plods on with occasional hints at amelioration but no actually remedy. The odds of Greece leaving the euro zone over the next year, meanwhile, have crept up to 65 percent, according to forecasting firm IHS Global Insight.

In Washington, Congress seems poised to march off the "fiscal cliff" at the end of year, by failing to forestall a huge set of tax hikes and spending cuts set to go into effect in 2013. Consumers and businesses, girding for some sort of meltdown, are starting to hoard cash and postpone spending decisions. Confidence has fallen back near recessionary levels. Stock analysts are cutting their earnings forecasts for big firms. And economists now think GDP growth could slow to a piddling 1 percent or less by the end of the year.

Stocks have responded to this gathering gloom by rising 9 percent over the past two months—nearing a high point for the year--as investors anticipate… well, nobody's quite sure what they're thinking. "Everyone talks about being pessimistic, but what I hear from my conversations with investors is generally optimism," Adam Parker, chief U.S. equity strategist at Morgan Stanley, wrote in a recent note to clients. "Most people seem to think that if the market has held up this well despite all the bad news, just think how well it can do when the news improves."

[See how Mitt Romney could have paid no taxes.]

Under this bad-news-is-good-news theory, the more trouble there is today, the fewer unhappy surprises there will be in the future—kind of like a patient with the flu who can't keep vomiting forever.

Meanwhile, fundamentals in the U.S. economy do seem to be improving. The housing market may have finally bottomed out, which means housing activity might start to contribute to economic growth instead of detracting from it. Consumers have been paying down record levels of debt, improving their ability to spend, some day. Banks are gradually easing up on lending standards. Big firms are sitting on more than $1 trillion in cash, which they'll use to start investing and hiring more once the economy seems to stabilize.

If this inner healing in the economy is what's occurring, the sweet spot may come in the first half of 2013, once the winners in the November elections have taken office and the next Congress has resolved those pesky uncertainties about tax and spending policy. "If fears in the economy are overblown, the relief stemming from an easing of those fears could have outsized benefits by first sparking a pickup in animal spirits and then continuing with a positive feedback loop," Jeffrey Rosen, chief economist at Briefing Research, wrote in his latest outlook on the economy.

[See how Washington is wrecking the economy.]

But Rosen and other economists also think growth could dip to less than 1 percent over the next few months, as just about everybody hunkers down to see what happens in Washington and Europe. That alone could form a ditch the economy won't necessarily bounce out of, just because some political uncertainty gets cleared up. "Uncertainty can be very damaging to long-term growth," says economist Nick Bloom of Stanford University, who helped develop an "uncertainty index" that measures the impact of unpredictable events on the economy. "My guess is we may have the election and a recovery in 2013, only to have it collapse again by next summer."

There are almost always opposing views on what the economy and the stock market will do in the future, which is why stocks move in jagged, up-and-down patterns. And it's not unusual for bad economic news to push stocks upward, since it may foretell, as an example, strong corrective action by the Federal Reserve or other policymakers.

What's unusual now is the extent to which stocks are discounting negative developments expected in the future. A new breed of pessimoptimists seems to believe that, sure, the economy will cool off even more during the rest of 2012, and there may even be some scary events that feel like another crisis. But after the deluge, good times await. If enough investors talk themselves into believing that, maybe it will actually happen.

Rick Newman is the author of Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.