Rational behaviour Is Making A Big Comeback

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Something interesting happened on Friday.

The Bureau of labour Statistics told the world that U.S. companies were adding jobs at a much faster pace than expected.

And stocks rallied and investors dumped so-called “safe-haven” assets like gold and bonds.

This is interesting because in recent months and years, there has been an idea floating around that good economic news would discourage the Federal Reserve from offering more monetary stimulus.  And market sceptics have been attributing stock market gains to the Fed.

More recently, Fed Chairman Ben Bernanke has explicitly said that the Federal Reserve would begin to taper, or gradually reduce, its monthly purchases of $85 billion worth of mortgage and Treasury bonds should the economy continue to improve in line with its forecasts.

Initially, markets freaked out a bit by these comments.  Stocks and bonds sold off hand in hand.

But with stock markets rallying on Friday and U.S. futures picking up this morning, some are now wondering if investors are now behaving more predictably.

“Investors seem to be coming around to the view that stronger economic numbers mean a stronger economy as well as a Federal Reserve that will adjust policy appropriately,” said UBS’s Paul Donovan in a commentary titled “Rationality Returns.”

Morgan Stanley’s Adam Parker shared a similar sentiment in a note to clients last week as he previewed earnings season, which unofficially begins this afternoon.

“[S]econd quarter earnings season is just around the corner and we think it will be more critical than normal,” wrote Parker in his note to clients.  “Why? Because unlike earlier this year, we now think “good is good and bad is bad,” meaning the fundamentals will be in focus.”

Parker believes that expectations for future earnings are too high.  And despite warning signs in previous quarters’ earnings seasons, the stock market has generally trended higher.

This time around, Parker believes that corporate warnings will justify lower stock prices and earnings expectations.

If Donovan is right that rationality has returned and Parker is right that bad news is coming, then we may be in for a rough couple of weeks.