Nick McDonald: When good data turns bad

Why does good news sometimes cause markets to fall?

When Good News Turns Bad

One of the most difficult things to understand about the markets for the uninitiated, is how good news can cause prices to fall. Or vice versa, why seemingly bad news sometimes causes markets to rise. It appears to make no sense - it's a paradox.

Last week was a perfect example when great economic data for the United States job market was released showing the lowest unemployment since 2008 pre-Global Financial Crisis times. This is a significant sign that the US economy is improving. Companies thrive in good economic times, more jobs are created and more profits are made so this all sounds like good news right? Yet stocks plummeted on the news. How can that possibly make sense?

Early in my career when I had an interest in the markets, yet little understanding of them, I would catch a pre-market headline such as ABC stock profit rises 10 per cent and think that was great news only to see the stock price fall 5 per cent when it opened. Why did this happen? The answer is that the market expected ABC profit to rise more than the 10 per cent announced. For arguments sake, let's say the market expected a profit increase of 20 per cent. This market expectation is always priced into the market price; it's the classic 'buy the rumour' situation. However great a 10 per cent increase in profits might be for ABC, it missed expectations and hence the price will fall to reflect the factual evidence versus the market expectations. Buy the rumour, sell the fact.

It's actually pretty simple and straightforward, you just need to be fully informed and know both market expectations as well as facts.

Quantitative Easing

The current situation with the global markets is a little more complicated but there is a method to the madness. In recent years the US economy has been in bad shape and just a few years back in 08/09 things got so bad and the markets plummeted so fast that the US Federal Reserve stepped in and starting pumping cash into the markets to stimulate the economy. You have probably heard the term 'quantitative easing' or 'QE' been bandied about but may not have known what it meant. Well in simple terms that's what QE is... pumping money into the markets to stimulate the economy. When a central bank's normal policy is not working effectively (like in 2008) and they want to stimulate their economy, QE is one of the tricks up their sleeve.

The US Federal Reserve has been playing this card since late 2008 and to date they have not stopped. The Fed has continued with QE for one simple reason, the economy was not sufficiently recovered to stop it ... until now perhaps?

Coming back to the great jobless figure stats in the US last week and the logic behind stocks falling on the news, here goes...

The US stock markets have risen strongly since early 2009 and one supporting reason for these on-going stock price rises is the Fed pumping money into the markets via their continued QE policy. The Fed is likely to continue QE until they see the economy is sufficiently recovered to look after itself without their assistance. The economic data out recently is undoubtedly showing great signs for the US economy, however it is getting sufficiently good that it is also predicted by the market that the Fed will start to slow their QE sometime soon. The Fed slowing or even stopping QE takes away one of the factors supporting price rises in stocks. Therefore, this good news for the economy is bad for the markets in the short-term as the market now prices in the possibility of reduced QE by the Fed and market participants start selling. So the markets will likely continue to fall in the short term on good news as we have seen already. The long-term however is another story.

Just like the good news for ABC stock rising 10 per cent is probably a good thing in the long-term, it can also be a bad thing in the short-term as the market readjusts prices based on the facts in front of them.

Looking Ahead

In the short-term this situation is likely to cause more volatility. We are in that strange situation of markets falling on good news and markets rising on bad news. This will probably continue until we know the Fed's position and they have made a clear public statement as to their future QE intentions. Until we know the facts, the market will continue to trade based on the 'probability' of what is most likely to happen.

At some point in the future QE will stop. I don't have a crystal ball so I can't tell you when that will be. What I can safely predict however is that when it happens, the US economy will be standing on its own two feet again and that can only be a good thing.

We will then be back to normal monetary policy conditions and low and behold, the market will start to rise on good economic news and fall on bad news. Just like the good old days before the term Global Financial Crisis was coined.

Nick McDonald is a New Zealander teaching everyday people how to trade the worlds markets via his company Trade With Precision.