The financial markets have shown a great tendency to surprise of late. A few weeks ago, several consecutive days of dramatic declines left the Dow Jones Index languishing at its lowest level in years and many analysts speculating that the bottom was nowhere in sight. More recently, the market is up markedly. On an almost daily basis, the major indices make huge moves in one direction or the other, but fortunately there have recently been more good sessions than bad. The Dow Jones is now well above its trough (at least at the time I am writing), and the same analysts who were predicting doom earlier in the month are now trumpeting a major rally.
Let me make a few quick points and then one major one. First of all, the market is following its usual pattern of overreacting to daily events and the ebb and flow of information. The cumulative prospects of all major US public corporations (which is what market performance is ultimately supposed to reflect), many of which have been around for decades and some for more than a century, do not swing back and forth by 3-4% on a regular basis in the span of 24 hours.
Second, stock analysts are notorious for making 180-degree turns in their opinions based on the slightest of whims, then abruptly going back the other way. Don’t lose too much sleep over that.
Third, volatility in and of itself is not a bad thing. Basic laws of the universe (the second law of thermodynamics, to be precise) and centuries of history tell us that as markets mature and have access to a greater base of information, they will tend to fluctuate more over time. This phenomenon is entirely expected and predictable. Don’t sweat it.
And now—the biggie! We are in the midst of the quarterly sideshow known as “earnings season.” Various companies report their results over a period of a few weeks, and the market responds accordingly. That is precisely what is happening at present. General Motors, Intel, Microsoft, IBM, Texas Instruments, Motorola, and 3M have all had their day and, depending on current performance and future prospects, the market has made its obligatory triple-digit move. Most of the numbers have been pretty decent relative to expectations, and thus a fairly healthy overall uptick has emerged from these seemingly chaotic gyrations.
Why is this process so important at present? There is one critical reason. In order for the market to react positively to strong earnings announcements, it has to believe them. That simple fact is monumental in the post-Enron, post-WorldCom world. Investors are doing what they always do—and that is the point. Quietly, and without fanfare, we have been given an unmistakable signal that much of the lost confidence has been restored. The signoffs on financial statements, audits, indictments, “perp” walks in handcuffs on the evening news, modest reforms, and correction mechanisms inherent in the market have had the desired effect.
When the information that forms the foundation of global equity markets is called into question, it has enormous adverse implications. The mechanism that ultimately drives much of capital availability in the world can neither function properly nor generate growth. If this condition persists for an extended period, it will inevitably have a pronounced negative effect on economic prosperity. The fact that the reaction to positive earnings has been exactly what you would expect is revolutionary in its implications. While we can debate the merits of triple-digit responses to deviation by a penny or two from anticipated earnings endlessly (and, I, for one, think they are far overblown), things are back to what passes for normal.
Whether the current rally is sustained remains to be seen (I feel pretty good about it, but that’s beside the point). What we do know, however, is that the remarkable system that permits both short-term rallies and long-term stock appreciation is alive and well and back in the groove. In the final analysis, that bit of news is much more noteworthy. As trivial as it may sound, buying is believing.