A stock market paradox, in which bad news about the economy is viewed as good news for stocks, may have run its course. If that’s the case, investors should reckon that bad news is bad news for stocks heading into the new year — and there can be a lot of that.
But first, why should good news be bad news? Investors have largely focused on the Federal Reserve in 2022 and its rapid series of large rate hikes aimed at curbing inflation. Economic news pointing to slower growth and fewer blips in inflation could serve to boost stocks on the notion that the Fed could start to slow the pace or even consider future rate cuts.
Conversely, good economic news could be bad news for stocks.
So what has changed? Last week, the consumer price index came in weaker than expected in November. While things are still heating up and prices are up more than 7% year-on-year, investors are increasingly confident that June inflation likely hit a high of over 9% in about four decades.
See: Why November’s CPI data is seen as a ‘game changer’ for financial markets
But the Federal Reserve and other major central banks said they intend to raise interest rates through 2023, albeit at a slower pace, and are likely to keep them higher for longer than investors had anticipated. This fuels fears that a recession is becoming more likely.
Meanwhile, markets are behaving as if the worst inflation fears are in the rear-view mirror and recession fears are now on the horizon, said Jim Baird, chief investment officer of Plante Moran Financial Advisors.
That sentiment was bolstered by manufacturing data on Wednesday and weaker-than-expected retail sales on Thursday, Baird said in a phone interview.
Markets “are likely to head back to a time when 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, co-chief investment officer at Truist, argued that a mirror image of the background may be emerging that gave rise to the so-called “tepper trade,” inspired by hedge fund titan David Tepper in September 2010.
Unfortunately, Tepper’s prescient call was for a “win/win scenario.” The “reverse Tepper trade” is developing as a lot/lot proposition, Lerner said in a Friday note.
Tepper’s argument was that either the economy would get better, which would be positive for stocks and asset prices. Or the economy would weaken if the Fed steps in to support the market, which would also have a positive impact on asset prices.
The current setup is one in which the economy will weaken, taming inflation but also hurting corporate earnings and challenging asset prices, Lerner said. Or instead, the economy remains strong along with inflation as the Fed and other central banks continue to tighten monetary policy and challenge asset prices.
“In any case, there are potential headwinds for investors. To be fair, there’s a third way in which inflation falls and the economy avoids a recession, called a soft landing. It’s possible,” Lerner wrote, but noted that the path to a soft landing is getting narrower.
Recession fears were evident on Thursday, as retail sales showed a 0.6% drop in November, beating forecasts for a 0.3% drop and the biggest drop in almost 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.
Stocks, which had posted modest losses after the Fed hiked interest rates by half a percentage point a day earlier, fell sharply. Stocks continued their decline on Friday, with the S&P 500 SPX posting a 2.1% weekly loss at -1.11%, while the Dow Jones Industrial Average DJIA was down 1.7% at -0.85% and the Nasdaq Composite COMP down 2.7% at -0.97%.
Read: Still Bear Market: S&P 500 Plunge Signals Stocks Never Hit ‘Escape Velocity’
“As we get closer to 2023, economic data will have a bigger impact on stocks because the data will give us the answer to a very important question: how bad will the economic slowdown get? That’s the key question as we enter the new year, because with the Fed’s relative policy on “autopilot” (further hikes through 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.
recession clock
No one can say with absolute certainty that there will be a recession in 2023, but there seems to be no question that corporate earnings will come under pressure and that will be a key driver for markets, said Plante Moran’s Baird. And that means earnings have the potential to be a significant source of volatility in the coming year.
“If 2022 was about inflation and interest rates, 2023 will be about earnings and recession risks,” he said.
It’s no longer an environment that favors high-growth, risky stocks, while cyclical factors could be favorable to value stocks and small-caps, he said.
Lerner of Truist said that until the weight of evidence shifts, “we maintain our overweight in fixed income, with a focus on high-quality bonds, and a relative underweight in equities.”
In stocks, Truist favors the US, a value bias, and sees “better opportunities below the market surface,” such as the equally weighted S&P 500, a proxy for the average stock.
Highlights of the economic calendar for the coming week include a revised look at third-quarter gross domestic product and the November index of leading economic indicators on Thursday. Data on personal consumption and spending, including the Fed’s preferred gauge of inflation, will be released on Friday, November.