Market Action Shows How Much Negativity Is Priced Into Stock Prices

One of the most important things to know about investing is that the stock market is a discounting mechanism. That does that mean? It means that expectations for future events are reflected in stock prices ahead of time, before the events actually occur. People who try to guess what the headlines next week are going to be, and invest accordingly, might not make any money in the market. Remember, stock prices go up or down not based on how well the underlying companies do, but rather how well the companies do relative to the market’s expectations.

I bring this up because today’s market action shows us that a lot of bad news has already been priced into equities. UBS (UBS) reported astonishing writedowns of $19 billion and Lehman Brothers (LEH) raised $4 billion of capital even though they claim they don’t really need it. Pretty bad headlines, but the Dow is up 260 points as I write this. Last month when Bear Stearns (BSC) nearly went belly-up the market reacted by dropping 1%, and has risen ever since. Many might have expected a far worse reaction to such startling news.

Now, this is not to say we are completely out of the woods and the market will soar from here. In fact, I think we will be range-bound for the foreseeable future. That said, it appears that things would have to get significantly worse for the market to take a huge hit from current levels. Hopefully first quarter earnings reports won’t have any big negative surprises. If that is the case, those who are claiming we are in a bottoming process might be right, in the short term anyway.

Full Disclosure: No positions in the companies mentioned at the time of writing