Sunday, May 5, 2019

Why Might Good News Make Stocks Go Down?

This runs the risk of being the most ill-timed post I've made since current recession risk is probably elevated. Don't take this as direct investment advice or as timely commentary on the current market. 

Consider a hypothetical couple planning for retirement and in the midst of that plan they are considering the upcoming year's vacation options. They can either have a staycation with peanut butter and jelly sandwiches and TV watching or a blowout Hawaiian vacation. 

As they consider which vacation they can afford, I arrive at their door having traveled from the future. Don't get caught up in the unrealistic assumption of time travel. The point is that I can credibly tell them the future looks very bright--perhaps I'm just Carnac the Magnificent. I tell them their investments will do well and times ahead are very good. How will they react? They go on the Hawaiian vacation. In other words they sell or forego savings (investments) and buy current consumption. 

The more technically accurate but less intuitive way of looking at it is the following. To get them to forgo enjoying the vacation now opting instead to save/invest, the market would need to pay them a higher rate of return (their discount rate, required rate of return, has increased). In order for current assets to have higher future returns, prices today must decline. Here is a fuller explanation from John Cochrane. His main point is that positive news can make market prices suddenly decline (if profit expectations stay the same but discount rates increase) but also negative news can make market prices suddenly decline (if profit expectations decline). 

If you find an unanswered question in this analysis, you are on to something. Good news can make the market decline but so can bad news. What exactly makes stock market prices suddenly go up? New, higher profit expectations could be the answer. Unfortunately, this is harder to come by than might be assumed. Remember, we are talking about long-term profit expectations. Those are tied to fundamental growth rates of ideas (innovation/productivity) and market size (population as well as density--a million people in a city are more productive than a million people spread sparsely over a large space). Moving that needle positive is much, much harder than negatively shocking it.

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