Stocks Can Do Better Than Goldilocks

I always enjoy reading the postmortems after a big move in financial markets to see just how the news media explains it.

For example, Friday's 208-point surge in the Dow Jones Industrial Average was attributed to a report showing that the U.S. economy created 175,000 non-farm jobs last month even as the unemployment rate ticked up to 7.6 percent. The spin? The May jobs data weren't strong enough to deter the Federal Reserve from its $85 billion in monthly asset purchases, but not weak enough to create new concerns that the economy was losing steam. In other words, the news was just right, as Goldilocks might have said.

Think about that for a moment. It's considered good news, or bullish for stocks, when the economy is too weak to survive on its own without the Fed's constant IV-drip. It follows that evidence of self-sufficiency, such as signs that corporations are investing some of their $1.78 trillion of idle cash in new plants and equipment, would be a negative for the stock market. The bond market is already showing signs of stress in response to the Fed's talk of tapering quantitative easing. The yield on the 10-year Treasury note rose 50 basis points in May and inched up more after Friday's report. Nothing the Fed does or says can prevent the inevitable rise in yields.

For stocks, interest rates are a two-way street. Because the risk-free Treasury rate is used to discount future cash flows in the determination of stock prices, higher rates reduce the present value of future earnings. But if interest rates are rising because the economy is getting stronger, demand for credit is rising and productivity is increasing, then expectations of better earnings should overwhelm the interest-rate effect.

Corporations reported record profits in the fourth quarter of 2012. After cutting costs to boost earnings, companies stand to benefit the old-fashioned way -- from increased demand for their goods and services -- if and when the economy takes off. That eventuality is a lot better than any Goldilocks fairy tale.

(Caroline Baum is a Bloomberg View columnist. Follow her on Twitter.)

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