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Five reasons bad news is not always bad news for investors

FILE PHOTO: Traders work on the floor of the NYSE in New York
FILE PHOTO: Traders work on the floor of the NYSE in New York

The nice two-day rally in the markets has given most investors some hope. It has been a long time since markets showed strong gains on strong breadth. But is that light at the end of the tunnel a nice blue sky, or is it an oncoming recession train? We wish we knew.

We are generally bullish — after all, markets have gone up for 200 years — but this year has been trying. Keeping calm is tough, and it is a skill investors need to work on. Investors generally sell when news is bad. But, of course, all the news is very bad at the market bottom.

As we will see, though, bad news is not necessarily so bad. Here are five thoughts to help ensure you are not selling at the exact bottom of this market cycle.

Your company made money yesterday

Whether your stock went up or down yesterday, chances are (if you are buying quality companies and not speculating), the company you own is richer than it was yesterday.

Let’s look at the most obvious example: Alphabet Inc., which has had US$95 billion in operating cash flow in the past year. With 365 days in the year, its cash flow is more than US$260 million per day. At the very least, no matter what the stock does, your share in the company is worth more as cash flow comes in at the rate of more than US$1.7 billion a week.

Think of that when one of the stocks you own declines. The stock is down, but cash may be up. It is a calming mantra in tough markets.

Stocks can still go up

As they say, there is always a bull market somewhere. For example, Biogen Inc., a health-care company that recently came out with good data on a later-stage Alzheimer drug trial, soared nearly 40 per cent on the Nasdaq, adding US$15 billion to its market capitalization. The news reminded investors that despite the doom and gloom, companies continue to go about their business, and sometimes business can be very good.

Along these lines, we recently ran a simple Bloomberg data screen to see how many stocks were actually up on the year so far. Our data tells us that 643 stocks in North America are up on the year. Of course, the data set contains more than 20,000 stocks, so that number may not be overly impressive, but it should remind us that even in a nasty bear market, not everything goes down.

You have to be there for the rallies

An investor’s performance is going to suffer badly if they miss out on the 10 best days of the year. This was exemplified this week, with the S&P 500 rising nearly six per cent in the first two days of the week. Investors holding cash did not go up, and investors short the market are now in a big hole for the week.

The best rallies occur in the middle of a bear market. This is why doing nothing is often a good strategy: it allows your portfolio to do well on the big up days.

The decline in small- and mid-cap stocks is a valuation contraction, not a fundamental problem

Credit Suisse Group AG this week noted the Russell 2000 (small-cap stocks) returned -23.5 per cent over the past 12 months, but that was composed of 27.7-per-cent growth in earnings and a 40.9-per-cent multiple contraction. In other words, companies — at least small-cap companies — are still growing nicely, but no one seems to care.

Just as in our Alphabet example above, companies are getting much larger through growth, but their market caps are getting smaller through lower stock prices. Common sense — often a rare quality in the market — implies this simply cannot last forever. Eventually, growth will get noticed. Are we heading for a small-cap rally?

Note the similar metrics for large caps (S&P 500) over the past year are 11-per-cent growth and a 25-per-cent valuation contraction.

Bad news will be good for a while

This one always confuses investors not paying close attention. One of the big reasons for the market rally this week was that the United States had 1.1 million fewer jobs open in August than it did before. To a common observer, that sounds like bad news, but it was manna from heaven for the market.

Right now, investors’ prime concern is inflation and higher interest rates. Any news that takes the pressure off, particularly on wages, is good news, because it means central banks may soon be able to stop their rate-hike cycle.

But wishing for bad news is a dangerous game: there is a fine line between bad news and a recession. Investors may not like what they’re wishing for if the bad news continues. But for now, bad news is good news, and good news is bad news. Got it?

Peter Hodson, CFA, is founder and head of Research at 5i Research Inc., an independent investment research network helping do-it-yourself investors reach their investment goals. He is also portfolio manager for the i2i Long/Short U.S. Equity Fund. (5i Research staff do not own Canadian stocks. i2i Long/Short Fund may own non-Canadian stocks mentioned.)

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