Bad News Leads to 36% Stock Market Surge

(MoneyWatch)  Back in March, MoneyWatch Editor-in-Chief Eric Schurenberg interviewed me on the subject of irrational investing (see video below). At that time, the stock market was continuing its downward trend to the tune of another 25 percent for the year, on top of the 37 percent decline in 2008.


As I rambled on in the interview about investor instincts in the face of market feast or famine, and how they are likely to lead us off a cliff, my own instincts were running amok. My inner voice was screaming at me to grab the 50 percent of my stock investments I had left and head for the nearest exit. It was doing its darndest to convince me that doing so would make the pain stop.

And in the eight weeks since that time, the news continued to be bleak:

• The US economy shrank at an annual rate of 6.1 percent in the first quarter of the year.
• Unemployment skyrocketed to 8.5 percent.
• Chrysler, an American icon, filed for bankruptcy and GM is preparing for one.
• The swine flu becomes a global pandemic.

How did the stock market react to all of this misery? By going up 36 percent as of May 4 -- from awful to awesome in what I call the miraculous market recovery of 2009.

Clearly I didn't have a clue back then that the market was about to have a ferocious rally. Nor do I currently have a clue of what the market will do over the next eight weeks. But there were a couple of things I did know back then.

First, I knew that the market expected more bad news. Only the swine flu was a surprise. See, the stock market anticipates news and that anticipation is generally built into the market's price. In good times, investors expect more good news and in bad time, they expect more bad news. Neither good news nor bad happens forever.

The second thing I knew was that a huge chunk of speculators had exited the stock market. Speculators think they are investors, but are actually the market's fair weather friends. They only sign on for the good times, and can easily be spotted in bad times lining up at their muster stations to jump ship. When presented with this buy high/sell low tendency, they offer all sorts of explanations as to how this is actually a rational approach. If that's rational, they'd probably be just as well off following Jim Cramer's advice. Speculators are the poster children of irrational investing.

Both of these things demonstrate why the simple (but not very easy) tool of rebalancing works. You have to buy stocks in bad times (when the market expects more doom and gloom) and buy them in good times (when we supposedly have new paradigms). This certainly doesn't work every year, yet even in the worst decade of the stock market in most of our lifetimes, a 60-40 stock and bond portfolio earned 36 percent through December 2008.

Nobody knows what the future holds, though many think otherwise, but the stock market is only appropriate for long-term investors who have both the time horizon and the grit to handle the pain. When I start seeing books again that predict the Dow going to 40,000, I'm going to get very worried. High expectations lead to bear markets. I'm hoping that the press will continue to predict the bad times that keep expectations low.