US Stocks Rise Because Of Bad Economic News?

WASHINGTON – Here is a clear economic news non sequitur, now considered “normal”, as financial markets lost any connection with the real economy. This is from a recent Reuters (May 18, 2015) news story: “U.S. stocks edged higher, with both the Dow Jones industrial average and the S&P 500 hitting records, as weak economic data suggested the Federal Reserve will hold back on raising rates any time soon”.

Bad economy, stocks go higher

Yes, this exactly it. US stocks edge higher on weak economic data. But, wait a minute. Shouldn’t it be the opposite? Shouldn’t it be that stocks are valued less when we have indications that the economy is not doing so well?

Well, not any more. And here is the perfectly logical and rational reason. Right now investing in stocks is practically the only way to put money to work. And this is because the zero interest rates policy, (ZIRP), inaugurated many years ago by the Fed in order to counter the Great Recession, has made any other form of investment unprofitable, and therefore unattractive.

Stocks are over valued

That said, everybody knows that because of this market distortion created by the Fed (in order to encourage more investments) stocks are over valued. If and when the Fed will end this incredibly long ZIRP stretch, interest rates will go higher and investors will have once again viable alternatives to buying stocks.

At that point stock valuations will be deflated, because stocks will no longer benefit from the “subsidy” provided by zero interest rates. And this is why all observers anxiously watch the Fed, trying to divine when and what speed the Federal Open Market Committee (FOMC) will take steps to go back to “normal” interest rates.

The absurd is now rational

But here is where all this becomes absurd. The conventional wisdom is that the Fed will continue to keep interest rates at zero, as long as the US economy remains  relatively weak and fragile. The moment we start gaining real velocity, (an indication that we are finally getting our act together), the Fed will start ratcheting up interest rates, this way ending the longest Wall Street party.

And this explains the non sequitur in the Reuters story quoted above: mediocre economy, higher stock prices. Please note all this. On account of Fed policies, these days “bad news” is good for investors. “Good news” causes stock prices to fall.

In my own words, the markets are extremely happy to see lackluster economic data, because this means that the Fed will have to delay any action on interest rates even further. Having taken note of this, as a fitting celebration, investor rush to buy more stocks.

Again, think about it. We keep buying stocks, not because there is true value in owning a piece of a successful company, but because the economy is weak, and so (thanks to Fed policies) there is an inherent advantage in owning over valued assets.

Fed-induced misalllocation of resources

So, there you have it. “Weak economy, Wall Street celebrates”. This is what the Fed has done. If the economy is good, then it is time to sell way over valued stocks. If the economy is bad or so-so, then we buy stocks, because we know that they will continue to be overvalued a little while longer.

All this is crazy. Our top monetary authority has created distortions that encourage a gigantic misallocation of financial resources. And nobody says anything.