By Mohamed A. El-Erian
FORTUNE -- So, good news was interpreted as bad news by the markets on Thursday while, on the very next day, good news was indeed good news? Are markets really that fickle? Are convictions really that shallow?
It is tempting to respond yes based on the view that, over those two days, investors reacted in an obviously inconsistent fashion to unanticipated news (and the unanticipated qualifier is particularly important). But we shouldn't do so before considering a more rational explanation, and one that may also shed light on what influences markets from here.
Let's start with the facts.
Before the market opened, the European Central Bank reminded everyone that central banks remain investors' very best friends. Remember, we are talking here of the most hawkish of the major central banks. Yet it surprised virtually everyone by cutting its policy rate by 25 basis points and sounding unusually dovish about the future.
Economic data appeared also supportive of equity markets. The third-quarter print for U.S. GDP came in significantly stronger than expected (a 2.8% expansion), suggesting robust economic growth dynamics.
Yet, ironically, all this materially good news did not translate into market gains. Instead, all three widely-followed U.S. equity indices (Dow, S&P, and the NASDAQ (COMP)) dropped by 1% to 1.9%.
There are several possible reasons for this notable discrepancy on Thursday.
With one-month gains of 6.5% to 7.1% for the three indices -- and with even more spectacular year-to-date gains of 20% to 30% in the midst of rather muted growth and periodic political dysfunction -- markets were technically vulnerable to some pullback. Meanwhile, the financial media has started spending more time talking about the potential for an equity bubble.
As intriguing as these reasons may be, they are not the only possible drivers for the price pullback. On Thursday it suddenly became popular again for some to revisit a notion that was quite destructive of markets back in May-June: that of questioning the U.S. Federal Reserve Bank's willingness to support markets going forward.
The stronger-than-expected GDP print led some to suggest that Fed officials may reconsider (earlier than expected) their September "non-taper" decision – that is maintaining an "as is" policy stance which is highly accommodative.
Put another way, it was felt that the Fed may now have more reason to reduce its monthly purchases of market securities (i.e., taper) -- and do so for more than one distinct reasons: Not only did economic growth come in stronger-than-expected, but both the Twitter outcome and increased talk of an equity bubble could push the Fed to worry again about the "costs and risks" of its prolonged policy experimentation.
The result was a broad-based sell-off in virtually every risk asset -- equities, investment grade bonds, high yield, etc ... And the less-liquid and more-technically challenged ones, such as emerging markets' local positionings, were particularly hard hit.
On Friday markets were again surprised before the open by better-than-expected economic news -- this time in the form of the October jobs report.
While the data was distorted by the impact of the October government shutdown, there were enough elements that were deemed unambiguously positive (such as the +60,000 revisions to prior data and the private sector job gains of 212,000) -- so much so as to lead many to believe in consequential stronger U.S. economic performance from here.
But rather than do a Thursday repeat and sell off on the news, the major equity indices surged by 1.1% to 1.6%. In the process, new records were set.
This time around, good news was indeed good news.
It may well be that there is a rather simple way of reconciling these seemingly two very different (indeed clashing) market reactions -- namely, the growing investor recognition that only a solid and durable recovery in fundamentals provides for an eventual normalization of monetary policy that occurs without notable disruptions to markets.
Indeed, you could -- and I would -- go even further: Given initial economic/political/policy/market conditions, economic escape velocity is the only way to ensure that markets are able to internalize smoothly monetary policy normalization over time.
Over the last few years, the Fed has repeatedly inserted a powerful wedge between market prices and fundamentals (e.g., via QE2, operation twist, QE3, and ever more aggressive forward policy guidance). Its hope, and that of many of us, is that the former (buoyant market prices) would pull up the latter (sluggish economic fundamentals), thereby also allowing for orderly policy normalization. The fear -- and, unfortunately, it cannot be dismissed easily -- is that growing policy ineffectiveness will result in the wrong type of convergence.
The combination of Thursday and Friday's economic data releases have been a lot more supportive of the Fed's policy bet, especially when compared to market consensus expectations.
Such an outcome would need to be solidly sustained in the months to come so that, at the macro-level, materially-stronger fundamentals validate and enhance current market prices while providing for a return to less experimental policies. In the meantime, look for intra-asset market differentiation to become a more pronounced component of investment strategies, including greater equity and corporate bond concentration on solid-balance sheet companies, front-end fixed income exposures, and emerging markets strong enough to resist the temptation to return to some pretty bad old habits, as well as more cautious assessments of liquidity risk.
Mohamed A. El-Erian is the CEO and co-chief investment officer of PIMCO.
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