Nearly two weeks ago, I wrote that there were a couple of things suggesting that a correction was coming soon, and that moving to a more defensive portfolio in preparation for that made sense. The two things that I talked about then, high demand for the relative safety of bonds and a market that was ignoring bad news, still apply and my view hasn’t changed. I still believe that a correction, and possibly one that is both sizeable and sharp, is coming at some point soon. However, as I have pointed out, bearish thoughts do not always warrant action. The risk reward calculus of positioning for a drop rarely works in your favor and price action this week has demonstrated why that is so.

The stock market is a forward discounting mechanism, so the most important driver of prices is not what has happened but what is expected to happen. The overall mood of traders and investors is often more impactful than hard news and, to quote an old traders’ saying, the market can stay illogical a lot longer than you can stay solvent. There were signs this week that that is happening now.

Going into a Fed meeting where a rate hike was broadly anticipated, we saw a market that refused to care. The idea of a “dovish hike” took hold. In other words, the FOMC could raise the Fed Funds target rate by the expected one quarter of a percent, but, by using their words, indicate that that was done in a dovish way. That sounds logical and, in many ways, that is what we got. Janet Yellen set forth a very cautious plan for reducing the Fed’s bloated balance sheet.

The central bank’s asset holdings have ballooned from under $1 trillion in 2008 to around $4.5 trillion today. The Fed understands the distortion of the market that results from that and the need to rectify the situation, but also the dangers of fully reversing the policy of the last six or seven years and dumping those bonds on the market. Their plan to simply let those bonds mature should result in a very slow reduction in holdings but without too much disruption.

The key here is that I used the word “should”.  That is because this is something that has never been attempted before. We therefore have no idea how it will go. Under normal circumstances you would expect uncertainty to spook traders and investors, but there is little sign of that now. As you can see from the chart, while there was a brief selloff when the news of the rate hike came and during Yellen’s comments on Wednesday stocks quickly recovered almost all losses. Yesterday again, after opening lower, the S&P 500 gained significantly during the day. Every dip seems to bring out fresh buyers.

Now, if those things were done in the light of a strong economy in danger of overheating and a worry-free future, ignoring them would be fine. That is not the case. If anything, recent data suggest that we are going through one of the periodic wobbles that have characterized this recovery. 

The paradox is the tendency of the market right now to ignore bad news and place a lot of hope in future policy changes is both the reason to be cautious and the reason not to. Caution has been thrown to the wind and the optimism driving things is based on policy initiatives that are looking increasingly less pressing to a White House and Republican congress under siege. That should make a correction from here inevitable. Or, if you prefer, it would be foolish to sell when buyers are still there to stop any drop in prices, even in the face of tighter monetary policy, record highs and an unstable political situation.

That is the essential contradiction that bears always face. The very fact that the market is ignoring bad news is both a reason to sell and to buy, and if you sell too early you can miss so much upside that even when the correction comes you still fall short of making back what you missed out on. To paraphrase Kermit, it ain’t easy being a bear.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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