Why is too much "good news" bad for U.S. stocks?

Good news will be seen by the stock market as bad news that the Fed will continue to raise interest rates for a longer period of time, and vice versa.

Although the U.S. stock market currently seems to be rising due to a series of good news, the stock market really doesn't want to hear too much good news.

The recently released economic data has been quite good and the stock market has also performed quite well.

Data released last Thursday (November 30) showed that the PCE price index, the inflation indicator most closely watched by the Federal Reserve, is falling. The day before, the US government revised up the third quarter real gross domestic product (GDP) growth rate from 4.9% to 5.2%.

This shows that inflation is falling, the economy is growing rather than slowing, and while talk of a recession has not gone away, it is no longer as intense.

From a seasonal perspective, November is usually a relatively strong month for U.S. stocks, but this November, the three major stock indexes not only performed strongly, but also set their best November performance in three years.

Dow Jones Market Data showed that the S&P 500 rose 8% in November, its best November performance so far in 2020. The Dow Jones Industrial Average rose 9%, also its best November performance so far in 2020. The Nasdaq Composite Index, which has been rising this year, rose 11% in November, its best November performance so far in 2020.

As of the end of November, the S&P 500 has risen 19% so far this year, the Nasdaq has risen 36%, and the Dow has risen 8.4%.

As a result, the year-end buying that is common every year and solid economic data give investors more reasons to buy in. Continued GDP growth is expected to translate into higher corporate profits, and corporate profits have been beating expectations.

These are the dynamics that have supported the stock market's gains over the past few weeks, but don't believe the saying that "Wall Street likes everything to look rosy."

That's not the case.

The hard truth is that the stock market doesn't want to hear too much good news on the economy right now.

For example, most of this year's gains have come as inflation has fallen to nearly 3% from a peak of more than 9% last year, suggesting that stocks want to see demand in the economy cool.

Cooling demand could in turn allow the Federal Reserve to keep interest rates steady or even cut them in the coming months.

Indeed, when the S&P 500 began to rebound in late October from its earlier multi-month lows, the fed funds futures market was pricing in a 45% chance of a rate cut in March of next year, up from around 11% at the start of the rebound.

This is because, in addition to the recently released GDP data, there are many economic data that are lower than expected. According to data from 22V Research, in mid-November, the Citi US Economic Surprise Index, which reflects the gap between a basket of US economic data and market expectations, fell from 75 a few weeks ago to nearly 25.

The sharp decline in the indexes was welcomed by stock markets as a sign that many parts of the economy are slowing, while inflation is cooling further and the Federal Reserve is almost certain to stop raising interest rates.

Still, stocks could rise in the face of bad news in the future. Any sign that the economy is too strong would reduce the likelihood of a rate cut or increase the likelihood of another rate hike, which would put pressure on consumer and corporate spending. Reduced spending would lead to lower earnings expectations, causing stocks to fall before earnings actually fall.

“Good news on the economy in 2024 could be viewed by the stock market as bad news for a longer period of Fed support with rate hikes, and vice versa,” said Chris Harvey, chief U.S. equity strategist at Wells Fargo.

This sounds complicated. The S&P 500 cannot currently withstand the pressure from further increases in interest rates.

Perhaps the only easier way to understand this is to remember that this is still a “bad news is good news” market.