The Reason That Good Economic News Is Bad for the Market

The New York Stock Exchange in New York on Sept. 27, 2022. Mary Altaffer/AP Photo

Commentary 

Many of you may have noticed a recent trend whereby good economic news causes the stock market to fall. Theoretically, higher than expected gross domestic product (GDP), or lower than expected unemployment, would be good for the economy, corporate earnings, and the stock market. During normal times, and over the long run, that’s true. Recently, though, we’ve seen the opposite. So today I’m going to explain why the market has been moving in counterintuitive ways when we get important economic news.

While efficiency of labor and corporate earnings are key determinants of the economy and stock valuations, it’s interest rates that cause large short-term moves. There are many reasons for this, but two are important. First, higher interest rates lead to higher bond yields, which drains money out of the stock market and then moved into bonds. It’s an influencer of supply and demand between different investment vehicles.

An example will help illustrate. A year ago, the two-year Treasury bond yielded just over 0.2 percent. That means that if you bought a $1,000 bond, you’d expect to make just over $2 in two years. That’s not appealing, it’s far below the level of inflation, and it led many investors to pile into stocks regardless of valuation. Market professionals sometimes talk about TINA (“There Is No Alternative”) as a way of saying that even though they might not want to invest in an inflated stock market, earning 0.2 percent on a two-year bond isn’t a viable option for them. With no alternative, they buy more stocks.

As of this writing, the yield on the same two-year bond is above 4 percent. That’s about 20 times the yield from just a year ago, and is at a level where people will move money out of stocks in order to take the guaranteed return of 4 percent. So, we can see how higher interest rates leads to higher bond yields, which then leads to money shifting out of stocks and into bonds.

The second big reason that higher interest rates affect the stock market is interest represents the value placed on time in the market. That relationship is particularly important in long-duration assets like many high-growth technology stocks. “Long-duration” is just a fancy way of saying that most of the earnings, or free cash flow from the company, is expected to come far in the future. Amazon is an excellent example of this. The company produced a high revenue growth rate combined with negative earnings for many years. Eventually, all of that revenue growth led to substantial earnings, but investors needed to wait years for that to happen.

Here’s where higher interest rates enter the picture. Let’s say a company will produce $100 of earnings in 10 years. A year ago, the 10-year Treasury yielded 1.33 percent. Discounting that $100 of earnings back to the present at that rate means the current value of those earnings would be a little over $87. The current 10-year Treasury yield is near 4 percent. Discounting the same earnings back would produce a current value of just under $68. The present value of the same earnings moved more than 20 percent. The markets are down this year primarily due to interest-rate hikes, and the reason the tech-heavy NASDAQ Composite Index is down more than the diversified S&P 500 Index is because the high-growth NASDAQ is more sensitive to changes in interest rates.

The Fed Moves In

What all of this means is that, in the short term, the actions of the Federal Reserve have an outsized impact on the market. As long as inflation is high and unemployment is low, the Fed will keep increasing rates, which is what is causing the stock market to fall. Federal Reserve Chairman Jerome Powell has said that he’s willing to accept higher unemployment in order to reduce inflation, but it’s clear that he and the other Fed governors are concerned about causing a recession more significant than the one we’re already experiencing.

So, when we get a “good” unemployment report showing that almost everyone in the United States who wants to work has a job, that’s good for the economy, but that also makes it feasible for the Fed to keep raising rates. When we get a “good” GDP number showing that productivity hasn’t fallen as far as feared, that’s also good for the economy, and also makes it easier for the Fed to keep raising interest rates.

The only two things that will cause the Fed to stop raising rates are a meaningful reduction in inflation, which we haven’t seen yet, or a recession bad enough that people in Washington, D.C. stop debating whether it’s a recession and accept that the economy has become bad.

As a result, when we get “good” economic news, the market fears that the Fed will keep raising rates, and that leads to lower equity valuations. When we get “bad” economic news, the market starts to price in a slowdown in interest-rate increases and begins to project when the Fed will go back to lower rates again. That causes the market indexes to rise.

I question the wisdom of having a central bank staffed by people who have never run a business or make payroll attempt to steer the economy with short-term interest-rate changes and press conferences, but addressing that topic would take a book.