05/14/2009 05:12 am ET | Updated May 25, 2011

Fear Recedes

The economy continues to worsen: GDP is contracting. Unemployment is at 8.5%. Housing still swoons despite the lowest mortgage rates in recorded history. The horrible realities of a brutal recession -- layoffs, shuttered storefronts, bankruptcies and liquidations--get worse by the day.

Why then would the stock market have risen to 8,000 -- up from its low of 6,547 --
over the past few weeks?

One possible reason is that the stock market recovers well ahead of the real economy. If this market behaves like any other over the past century, it will rise long before the good times return. In the five years following 1932, the Dow soared from 41 to 194, while bread lines and Hoovervilles still dominated the American landscape.

Has the market bottomed? The unsatisfying answer is no one knows. It's unknowable whether the market will go back below 6,500, slump to 5,000, or continue its ascent.
What we do know is that the market will lead the way and the economy will follow. A common question is why?

One reason is economic, the other psychological -- and the two are related through that intersection of behavior and finance.

As an economic tool, the market is a discounting mechanism: it attempts to gauge future cash flows long before they occur. Given the time-value of money, the eventual profits of companies are worth less in the present, adjusted for inflation and risk. All the estimated inputs -- a mixture of educated conjecture, countless assumptions and irrational emotion -- fluctuate second-by-second, desperately trying to set prices.

The market has no interest in today's cash flows, since they're already here. Like a mare with blinders, the market only looks ahead, never sideways or backwards. When the Dow rises or falls, it's changing its economic assumptions for future profits, not present ones.

As respected value investor Bill Miller says: "If it's in the papers, it's in the price." Everything that's collectively "known" is already priced into stocks. A frequent question asked of all value managers is: "Don't you read the papers? Don't you see what's going on?" Of course. But what's in the papers is already known, collectively, and to the market especially. To trade on news doesn't work since savvy traders discount headlines instantaneously. Common knowledge doesn't influence markets, only true surprises do.

Anyone who follows individual stocks has witnessed the phenomenon of a stock declining for weeks and then rallying sharply as soon as terrible earnings are announced. The stock price factors in the bad news ahead of the earnings announcement -- then rises once traders look to the next quarter. Or the stock that rises on favorable expectations then collapses as soon as the good news becomes a certainty. Hence, the old market saw: buy the rumor, sell the news. The counterintuitive nature of stock movements -- that they often fluctuate inversely to conventional expectations -- is a result of the pricing mechanism of markets, which discounts the future to the present.

The second reason is psychological. The market reacts to emotions instantaneously. Market prices, influenced by thousands of mouse clicks per second, assimilate the current mood, or "sentiment," at any given instant. Imagine the market as a vast monitoring device, taking the pulse of mass psychology moment by moment. When optimism reigns, prices rise. When panic takes hold, prices immediately reflect that sinking feeling: bids are overwhelmed by sells.

If one person is panicked by the broad economic climate, so is everyone else, preventing the panicked seller from profiting by his own panic. Said simply, when the seller sells, he's dumping stocks at prices that already reflect panic. He cannot "get out" before the price goes down. The price is already down when he places his order.

The early stages of a recession are the most terrifying, as people grapple with the switch from optimism to despair. Given novelty's sway on human emotions, the first feelings of panic are felt the most intensely, are the most surprising, and thus cause the greatest fall in prices. The panic about what may happen long precedes what actually happens. The fear of losses long precedes the actual losses: the imagination reacts first.

Panic is, by definition, a short-term emotion. It can only grip the psyche for an instant since the mind soon acclimates to its cause. As Thomas Paine wrote in The Crisis (the anonymous pamphlet published when America appeared to be losing the Revolutionary War):

Panics, in some cases, have their uses; they produce as much good as hurt. Their duration is always short; the mind soon grows through them, and acquires a firmer habit than before.

Once the mind grows through its panic, the anxiety dissipates. The mere dissipation is what allows prices to recover from distressed levels. As if in a vast, collective sigh of relief, markets instantaneously rise to reflect the fading of fear. It doesn't require any positive economic signs to create this price rise, only the conversion of apprehension to acceptance. Once the anticipation of losses becomes the reality of losses, panic recedes. The unknown becomes known. Nauseating dread turns to resignation.

We have no idea what the market will do next week, next month, or even next year. But we do know that stock prices will recover before the economy -- and that their long-term movement will be upwards.