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Investing Specialists

When Bad News Is Good News

How could bad employment numbers help the market?

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Poor Labor Report Drives Stock Market Higher
This week's employment report was bad enough to convince investors that the Federal Reserve will activate its contingency plan to reduce long-term interest rates through so-called quantitative easing. Under these programs, increased Fed direct purchases of debt securities means higher demand for those instruments. With higher demand comes higher bond prices, which means lower yields for borrowers. (Bond prices and yields move in opposite directions.) With headline employment figures down some instead of flat as expected, there was no impetus for the Fed to stop its baby steps toward more monetary easing.

Theoretically, lower rates could help the stock market in many ways. Lower interest rates mean that stocks, especially stable dividend-paying stocks, are more attractive to investors. Second, lower rates, if believed to be sustainable, mean higher price/earnings ratios (a lower discount rate on future earnings). Some could also view lower rates as being stimulative of overall economic growth and a positive for corporate earnings. Hence, recent bad economic news has increased the likelihood of more easing and perversely helped the market.

Further Easing Looks More Likely than Just a Week Ago
Last week I pooh-poohed the probability of extensive easing based on increased inflation prospects and an economy that continues to improve, albeit at a snail's pace. Also in the back of my head was the concept that low rates aren't convincing scared consumers and investors to let loose with their spending. In my opinion, jobs, incomes, and consumer confidence are holding back the economy--not high rates. Combining that with some internal Fed dissension on that issue made me think, just a week ago, that the market was overweighting the probability of more easing. Some statements by Bernanke and other Fed members this week, along with a sloppy employment report, may eventually prove me wrong.

Robert Johnson, CFA does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.