On the stock side, a weaker economy would probably be cheered initially strictly on the basis that it would keep the Fed from reducing the flow of liquidity (the bizarre “bad news is good” dynamic we discussed in Up Is Down and Down Is Up recently). Depending on how bad the economic news is, that initial reaction might give way to the realization that a weaker economy is typically bad for business and company profits, putting downward pressure on stock prices.

Reasons Not To Fear

So while the markets will likely continue to be volatile for a while, we’re left with a situation where if the economic news in the coming months is good, bonds will probably fall but stocks will likely start rising again. On the flip side, if the economic news in the coming months is bad, bonds will likely rise from current levels, while stocks could go either way. It seems unlikely that both stocks and bonds will continue to fall for an extended period of time, because what is good for one is bad for the other, and vice versa.

Once again, we’re left in a situation where basic diversification seems likely to dilute the pain of a market adjustment. Sure, it could take a while longer for these fundamentals to trump the initial knee-jerk reaction to the Fed. But the more asset prices revert to “normal” (which is what has been happening the past two months), the more fundamentals should kick in and the less weight the Fed’s “extraordinary” policies should carry. And that is a development we’ve been looking forward to for a long time.

Mark Biller is the Executive Editor of Sound Mind Investing. His writings on a broad range of financial topics have been featured in a variety of national print and electronic media, and he has appeared as a financial commentator for various national and local radio programs. Mark is also the Senior Portfolio Manager of the SMI Funds.

Publication date: July 15, 2013