The Fool FAQ

Market Tanks on Good News?

The Fool FAQ

Why does the stock market often tank when there's good economic news?

It's all related to interest rates and inflation. Alan Greenspan and his buddies at the Federal Reserve set interest rates, trying to keep inflation at bay and promote a healthy economic environment. When positive economic news is released, such as falling unemployment, rising wages, or growing national productivity, the specter of possible inflation is raised. Economies growing too quickly can spur inflation, with too much currency in the marketplace leading to the weakening of the dollar and rising prices.

To try to stem inflation, the Fed notches up interest rates to decrease the amount of borrowing and slow down the economy. The possibility of rising interest rates renders bonds more attractive, as they offer fixed incomes. Investors pull money back from stocks, which are hit doubly with the threat of shrinking corporate earnings and with the attractiveness of growing bond yields.

Stocks compete with interest-bearing investments. If the interest rate on the 30-year bond rises above a certain level, bonds become more attractive to investors than their equity counterparts. Next, stocks become less attractive during periods of rising interest rates because earnings growth is more likely to slow. Companies will borrow and invest less money for growth during these times, and consumers (and employees) also feel squeezed and are less confident about spending.

Imagine a doubled-edged sword that swings from side to side. The sword goes from bad, to bad again, but it should then settle in the middle at "good." Fools should avoid focusing on the "bad" times when the sword is swinging (this is when the stock market is most volatile), and instead focus on the "good" that eventually arises once the sword settles. An explanation of this:

  1. Inflation is not good.
  2. Rising interest rates are not good.

But, in many situations, you can't kill inflation without first raising interest rates. You need to take at least one "bad" to eventually get to the good. And usually the two bads go hand-in-hand. (The sword does a swing, another swing, and then rests...)

The Fed wants the economy to experience sustainable growth without undue inflation. This is the bliss that we've experienced for most of the 1990s. We've had a growing economy with low and even declining interest rates, which fuels further growth. But you can't let the growth get out of hand -- you can't let the fire spread too fast or it grows too high and out of control. Throw some water on the fire, experience the short-term darkness, but then expect things to continue to burn again at a sustainable pace. (Raising interest rates to fight inflation can remind a person of the old cliche: Short-term pain for long-term gain.)