Why Bad News Soon May Just Become...Bad News
The days of markets turning bad news into good news could be winding down if pressure continues to grow on the Federal Reserve to begin unwinding its monetary easing policies while the economy weakens.
As long as the Fed has been at the ready with its trillions in liquidity, stock investors have used negative readings on the economy simply to anticipate more central bank assistance.
But the market now finds itself at an interesting cross-current: The bad economic data, such as this week's Institute for Supply Manufacturing negative reading, is coming in conjunction with calls for the Fed to ease its foot off the gas.
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"Having been rather patient in awaiting a turning point for U.S. economic data, we do not view this as a welcome development," Andrew Wilkinson, chief economic strategist at Miller Tabak, said in response to ISM data showing contraction in the manufacturing sector and flattening job growth.
"We would also comment that the accompanying weakness in domestic data will probably prove insufficient in fluffing equity investors' appetite to buy purely and simply because the Fed is more likely to remain at the wheel," he added in comments that, if correct, would mark a sharp divergence in investor behavior.
Since the post-financial crisis bottom in 2009, the Standard & Poor's 500 has soared 145 percent while the Fed's balance sheet has quadrupled to $3.4 trillion.
In the latest version of its quantitative easing program, the Fed is buying $85 billion a month of Treasurys and mortgage-backed securities.
That time also has seen a strong run-up in corporate earnings, from $43 a share as of the first quarter in 2009 to the current $123.38.
Profit growth, though, is slowing and revenue growth has come to a near standstill.
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Earnings per share in the first quarter came in at a 5.15 percent gain and are expected to slide to 3.4 percent in the second quarter—down from initial estimates last summer of 15 percent.
Those profits have come due primarily to cost-cutting, as sales growth was just 1.1 percent in the first quarter.
At the same time, calls have begun for the Fed to begin easing up on QE and allowing interest rates to begin what is expected to be a long process toward normalizing.
Those calls have come both within the Fed's Open Market Committee—where members have begun worrying about long-term inflation threats and heightened risk-taking by investors—as well as in the markets, where Pimco's Bill Gross released a scathing letter this week that blamed the Fed for weak economic conditions.
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The normally bearish economist Nouriel Roubini has changed his tune, at least inasmuch as he believes the market could rally for the next two years as the Fed keeps easing—but that will last only until the wealth gap between Wall Street and Main Street gets stretched too far.
"Bad news is also good news for the market," the head of Roubini Global Economics told CNBC. "You have this gap between the economic activity, between the U.S. and other advanced economies and emerging markets being weak, but this is trumped by liquidity."
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What the Fed does, then, will be equally important as to why.
If the Fed can convince the market that it is withdrawing QE money creation because the economy is stable, the market would be more likely to absorb the hit with minimal disruptions.
But if the reason for exiting is that the Fed is worried about the side effects that Gross and others have warned about, that would be more disruptive.
"If the Fed continues to make noises about the tapering and the reason is they are worried about risk, as opposed to them tapering because of a stronger economic foundation, that is worrisome for the market," said Quincy Krosby, chief market strategist at Prudential Annuities.
Some FOMC members, Krosby said, "are worried about risk building built up in the underpinnings of the market, that QE is causing risk in the search for yield."
Despite the continued run-up in stock prices, other indicators are showing that while economic growth continues, expectations are getting unhinged from reality.
Bespoke Investment Group uses a proprietary model that compares economic reports against estimates, and it is near a 15-year low in terms of positive surprises.
If that trend continues, bad news is likely to become nothing more than bad news.
_By CNBC.com Senior Writer Jeff Cox. Follow him on Twitter at JeffCoxCNBCcom.