Why Good Economic News Isn't a Good Indicator for Stocks

Last Updated Dec 28, 2010 10:08 AM EST

(This article is part of a series on how to view economic news. To see some of the recent good economic news, see Tuesday's post "Good Economic News Finally Arrives.")
Stocks have rallied tremendously since March 9, 2009, with the S&P 500 Index returning about 90 percent since then (once you include dividend yields). Having missed out on one of the greatest equity rallies in history, investors finally appear to be convinced that it's now "safe to go back in the water."

The rally we've had in stocks is a result of the market anticipating that the economic news would be much better. Thus, the good news is already embedded in prices. The fact that the news is now better isn't a good reason to buy. (If anything, investors should be selling, not because they think the market will do poorly, but because they should be sticking to their plan and asset allocation.)

The huge rally will require investors (at least those with plans) to rebalance their portfolios, selling equities to keep them within tolerance ranges established in the asset allocation/rebalancing table.

I'm certainly not implying that stocks are bad investments now. In fact, despite the large rally, valuations still look quite reasonable. For example, the investment firm BlackRock is forecasting S&P 500 earnings of $92. Applying an average P/E of 15 to that gives us an S&P 500 of 1,380. Yesterday, the S&P 500 closed around 1,260. That means a P/E of 15 would requires earnings to be only about $84. The problem is we don't know how accurate the forecasts of the economy and profits will be, and we can't foresee the future as to geopolitical risks that can develop.

The world remains a very risky place and not just because of the deep financial mess that we have created (with many countries facing severe long term budget deficits). There's also potential problems with North Korea, Iran, Afghanistan and who knows where next.

Unfortunately, the historical evidence is clear that there are no good forecasters who can protect us from the inevitable bear markets. Investors simply must accept the fact that stocks are always risky investments, no matter how good the economic climate may seem. Thus, bear markets must be built into plans, meaning that the investment policy statement should ensure that you don't take more risk than you have the ability, willingness or need to take. Anticipating that bear markets will occur will help you stay disciplined.

The most successful investors understand that discipline -- adhering to your plan -- is the key to success. And if you simply can't resist trying to time the market, consider the advice from Warren Buffett to be greedy when others are fearful and vice versa.

More on MoneyWatch:
The Smartest Things Ever Said About Market Forecasting Don't Listen to Economic Forecasters The End of Social Security's Interest-Free Loan Do Municipal Bonds Still Have a Place? How to Build a Bond Portfolio
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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.