Is Good News Bad for the Stock Market?

It’s seemingly irrational market behavior.

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Is good economic news bad for the financial markets? Federal Reserve Chairman Ben Bernanke said last month that based on their projections of 1) continuing gains in the labor market, 2) improving moderate economic growth, and 3) inflation moving toward their 2% target, the federal reserve may start cutting back on economic stimulus. The stock market reacted negatively.

Investors apparently equated signs of an improving economy with an end to the Fed’s stimulus, which accounted for this year’s strong stock market performance. It appears as though investors thought that without the stimulus, the rally ends and stock prices sink lower. Are stock prices no longer supported by earnings? An improving economy should support strong corporate earnings fueled by consumer spending based on their confidence in the economy. Why would the rally end if the Federal Reserve is cautiously optimistic about our economic future?

This seemingly irrational market behavior could be due to a lack of investor confidence in the economy’s ability to grow without the stimulus. The Federal Reserve does not have a perfect track record of accurately predicting economic growth. Many analysts believe there are signs pointing toward slower growth in the second and third quarters. If the Federal Reserve withdraws its support too soon, they believe the US economy risks falling back into a recession.

In the long run, stock prices have usually followed earnings growth and current valuations are still reasonable compared to historic valuations. If the economy stays on its current track of moderate growth, with an improving job market and low inflation, the stock market rally could get back on track.

In the meantime, it’s reasonable to expect continued market volatility and more muted market gains in the second half of the year. Investors will be closely watching the Federal Reserve as they begin to wind down its asset purchase programs in late 2013 or early 2014.

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