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Why Bad Economic News Can Be Good for Stocks

On Wednesday, the stock market received a double dose of bad news. First, the government reported that the first quarter GDP fell a much worse-than-expected 6.1 percent in real terms. Combined with the fall of 6.3 percent in the prior quarter, it marked the worst six-month performance in 51 years and the first time the economy has contracted for three quarters in a row since 1975. Second, the yields on Treasury bonds rose, with the 10-year bond breaching the three percent level.

How did the stock market react? The Dow rose almost 169 points, or 2.1 percent.

If you're scratching your head over this seeming anomaly of bad news and good results, relax -- the explanation is actually simple. Let's begin with the GDP data. Like almost all economic statistics, economic-output figures are backward-looking. Those awful GDP results only tell us what happened in the past.

The stock market, by contrast, is forward-looking. In this case, the market was reacting to the news that almost half of the GDP decline was due to an "inventory correction." In other words, while consumer spending actually rose during the quarter by just over two percent, businesses were drawing down inventories. That sets the stage for a recovery, and that's what the market was looking at.

Rising bond yields are also often a negative for stocks -- but not always. If yields are rising because of inflationary pressure, that's bad for future growth, and thus for stocks. If, on the other hand, yields are rising because the economy is strengthening, that suggests an increase in demand for credit, which is usually good for stocks.

So over the long term there's basically no correlation between stock returns and the returns on long-term bonds. One plausible explanation for the stock market's rally was that we're seeing a reversal in the flight to quality. Last year's rally in Treasury bonds was fueled when investors fled risky assets for the safety of Treasury securities. The recent rise in Treasury yields -- which in upside-down bond-market logic means lower prices for Treasuries -- could be a sign that investors are more willing to take on risk by selling Treasuries to buy stocks and other risky assets.

We see signs of investor's increased willingness to take risk by the narrowing of the spread of Treasuries to Libor, municipals, corporate bonds, 30-year mortgages and auto loans. All these are positive signs for the equity markets.

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