Something every investor should understand is that the financial markets and the real economy are two different, often very different, things. Over the very long term, the health of a nation’s economy will be reflected by its stock and bond markets. But in the short term, the stock and bond markets are moved by the changing expectations of market participants as much as or more than they are moved by changes in underlying economic activity.

We should also understand that investor expectations are by no means fixed or even consistent from moment to moment. Take the U.S. stock market for example. At times, investors behave as if nothing can stop an inexorable march toward higher stock valuations. In these periods, all bad news is simply shrugged off or reinterpreted as contrarian indicators justifying the prevailing sentiment. One is reminded of Federal Reserve Chairman Alan Greenspan’s warning of “irrational exuberance” in December 1996, or of the 2007 housing bubble. 

At other times, mixed economic news – and let’s acknowledge that economic news is nearly always mixed – is viewed with a particularly jaundiced eye, and we can only see the dark clouds hovering over each new economic report.

What can be maddening to investors is when it seems that the market has turned things upside down. Good economic news is bad for the stock market and vice versa. It has often felt that way in 2013. The Standard & Poor’s 500 index is up 24 percent for the year as of this writing, and justifiably so in many respects – record earnings, improving housing prices, an unemployment rate that has fallen to 7 percent from 7.9 percent at the beginning of the year. 

But at times during the course of the year, it has seemed that any hints of economic recovery threatened the bull market. This was especially true when outgoing Fed Chairman Ben Bernanke announced in May the Fed’s intention to begin tapering its $85 billion per month in bond purchases. Bond yields soared, and U.S. stocks gave up ground. For a time, the financial markets seemed so rattled that the Fed was moved to walk back Chairman Bernanke’s comments in an attempt to reassure nervous investors.

For much of the second half of 2013, the market has seemed to walk a tightrope – searching on the one hand for sufficient economic progress to generate topline growth, but on the other hand desperately hoping to avoid anything that might prompt the Fed to begin to taper. It’s as though each day, investors were imploring the financial deities for the Fed to end its “extraordinary measures” and get back to normal – just not today!

How welcome a sign then that when the Fed finally pulled the trigger – announcing a $10 billion per month reduction in its monthly bond purchases on Dec. 18 – interest rates barely budged (the U.S. 10-year Treasury note yield rose from 2.84 percent to 2.94 percent), and the stock market rallied 2 percent.  

It’s important to say what we do not take from this market reaction, and that is any assurance of how the stock or bond market will perform in 2014. What we do see is that both the bond market and the stock market have accepted that a growing economy accompanied by a gradual ending to the Fed’s extraordinary measures is a move in the right direction. 

We agree.

The views expressed are those of the author as of the date of the article, are for informational purposes only, not meant as investment advice, and are subject to change. Miles Capital does not guarantee the accuracy or completeness of any statements contained in this material and is not obligated to provide updates.