A stock market paradox, where bad news about the economy is seen as good news for stocks, may have run its course. If so, investors should expect bad news to be bad news for stocks heading into the new year — and there could be plenty of that.
But first, why should good news be bad news? Investors have spent 2022 largely focused on the Federal Reserve and its rapid series of big rate hikes aimed at reversing inflation. Economic news pointing to slower growth and less fuel for inflation could serve to lift stocks on the idea that the Fed might begin to slow its pace or even begin to entertain future rate cuts.
Conversely, good news about the economy can be bad news for stocks.
So what has changed? In the last week, the consumer price index in November has been softer than expected. While it̵[ads1]7;s still very hot, with prices rising more than 7% year-on-year, investors are increasingly confident that inflation likely peaked in just over four decades above 9% in June.
See: Why November’s CPI data is seen as a ‘game-changer’ for financial markets
But the Federal Reserve and other major central banks indicated they intend to continue raising interest rates, albeit at a slower pace, into 2023 and likely keep them up longer than investors had expected. It raises fears that a recession will become more likely.
Meanwhile, markets are behaving as if the worst of the inflation scare is in the rearview mirror, with recession fears now looming on the horizon, said Jim Baird, chief investment officer at Plante Moran Financial Advisors.
That sentiment was reinforced by manufacturing data on Wednesday and a weaker-than-expected retail sales reading on Thursday, Baird said in a telephone interview.
Markets are “probably heading back to a period where bad news is bad news, not because interest rates will worry investors, but because earnings growth will falter,” Baird said.
A “Reverse Tepper Trade”
Keith Lerner, chief investment officer at Truist, argued that a mirror image of the backdrop that produced what became known as the “Tepper trade,” inspired by hedge fund titan David Tepper in September 2010, may be forming.
Unfortunately, while Tepper’s prescient call was a “win/win scenario.” “reverse Tepper trade” shapes as a lose/lose proposition, Lerner said in a Friday note.
Tepper’s argument was that the economy was either going to improve, which would be positive for shares and asset prices. Or, the economy would weaken, with the Fed stepping in to support the market, which would also be positive for asset prices.
The current setup is one where the economy is going to weaken, tame inflation, but also reduce corporate profits and challenge asset prices, Lerner said. Or instead, the economy remains strong, along with inflation, with the Fed and other central banks continuing to tighten policy and challenging asset prices.
“In either case there is a potential headwind for investors. To be fair, there is a third path, where inflation goes down and the economy avoids recession, the so-called soft landing. It is possible,” Lerner wrote, but noted that the path to a soft landing looks increasingly narrow.
Recession worries were on display Thursday, when November retail sales fell 0.6%, beating forecasts for a 0.3% decline and the biggest drop in nearly a year. The Philadelphia Fed’s manufacturing index also rose but remained in negative territory, disappointing expectations, while the New York Fed’s Empire State index fell.
Read: Still a bear market: S&P 500 decline signals stocks never reached ‘escape velocity’
Shares, which had posted moderate losses after the Fed raised interest rates by half a percentage point a day earlier, fell sharply. Stocks extended their decline on Friday, with the S&P 500 SPX,
with a weekly loss of 2.1%, while the Dow Jones Industrial Average DJIA,
fell 1.7% and the Nasdaq Composite COMP,
fell 2.7 percent.
“As we move into 2023, economic data will have a greater impact on stocks because the data will tell us the answer to a very important question: How bad will the economic downturn be? That is the key question as we begin the new year, because with the Fed on relative policy ‘autopilot’ (more hikes to start 2023) the key now is growth, and the potential damage from slowing growth, said Tom Essaye, founder of Sevens Report Research, in a Friday note.
No one can say with absolute certainty that a recession will occur in 2023, but there seems to be no doubt that corporate earnings will come under pressure, and that will be a key driver for the markets, said Plante Moran’s Baird. And that means earnings have the potential to be a significant source of volatility in the year ahead.
“If the story in 2022 was inflation and rates, for 2023 it’s going to be earnings and recession risk,” he said.
It is no longer an environment that favors high-growth, high-risk stocks, while cyclical factors can be good for value-oriented stocks and small-caps, he said.
Truist’s Lerner said that until the weight of the evidence changes, “we maintain our overweight in fixed income, where we are focused on high-quality bonds and a relative underweight in equities.”
In equities, Truist favors the US, a value tilt, and sees “better opportunities below the market’s surface,” such as the balanced S&P 500, a proxy for the average stock.
Highlights on the economic calendar for the week ahead include a revised look at third-quarter gross domestic product on Thursday, along with the November index of leading economic indicators. On Friday, November, data on personal consumption and spending, including the Fed’s preferred inflation gauge, is released.