Stock Market's Paradox: When 'Bad News Is Good News'

Understanding the 'Bad News is Good News' Phenomenon

It seems we've once again entered a phase where 'bad news is good news' for the stock market. This means that weak economic indicators are leading to a rise in stock prices. While this may seem counterintuitive, it's a scenario that often benefits equities. However, investors need to be cautious. If stocks fail to rally on positive news, it could be an indication that the economy is on the brink of a recession, and the stock market may be heading for a downturn.

The phrase 'bad news sells best' is often attributed to Kirk Douglas's journalist character in Billy Wilder’s film, Ace in the Hole. However, this concept isn't just applicable to the media. Stocks also frequently rally on negative news that would logically lead to a sell-off. This unusual situation can largely be attributed to the central banks' implicit support for markets.

Defining the 'Bad News is Good News' Regime

Recently, stocks have been rallying on the back of weaker economic data points, such as payrolls and the ISM. However, the 'bad news is good news' narrative needs a more solid foundation. To achieve this, we need to define what we mean by 'bad news is good news', identify the different regimes based on our definition, and examine how the market has performed during these regimes.

Claude Shannon, the father of information theory, proposed that the value of information lies in its ability to surprise. This is how markets often react to economic data. They respond not to the information itself, but to how much it deviates from expectations.

Economic Surprise Indexes and Market Regimes

Economic surprise indexes track the cumulative number of surprises. When these indexes are positive, it means that, on balance, economic data is exceeding expectations. Conversely, when these indexes are negative, it indicates that data is falling short of expectations. Based on this, we can identify four market regimes:

• Good news is good news (stocks and economic surprises rise together)
• Bad news is good news (stocks rise when economic surprises fall)
• Good news is bad news (stocks fall when economic surprises rise)
• Bad news is bad news (stocks fall when economic surprises fall)

Using the Bloomberg surprise indexes, which are divided by economic type (such as survey data and labor data), we can see that the market has recently re-entered a 'bad news is good news' regime. Most of the S&P’s gains since October 2022 have occurred during this regime, or the 'good news is good news' regime. These two regimes are generally dominant when the market is in a strong bullish trend, which isn't surprising given that stocks rise on both good and bad news.

Implications for Stock Performance

There's no significant difference if we limit the sample to the post-GFC period when the Federal Reserve's support for markets became more explicit. The percentage of time when bad news was good for stocks only increased slightly to 26% from 23%. The market rallying on any news is what you would expect to see more often, given that the market generally rises over time. However, without the Fed's support, it's likely that stocks would rise less frequently as they wouldn't be as shielded from bad news.

But what does all this mean for stock performance? When stocks are rallying on good or bad news, forward returns on all time horizons are above average. Therefore, the current regime is historically consistent with the S&P returning slightly above its average over the coming months. However, when stocks are selling off on bad news, it's not great for forward returns. The real concern is when stocks fail to rally even when the news is good. In this regime, stocks consistently underperform, performing poorly over the next one, three, six and 12 months.

How Does Bad News Boost Stock Prices?

So how does disappointing data cause stock prices to rise? One possibility is that bad data triggers a flight-to-safety bid in bonds, or a reduction in Fed rate expectations. The resulting lower yields could boost stock prices. This 'bad news is good news' regime is more likely when the stock-bond correlation is positive (on a rolling one-year basis) as opposed to when it's negative.

However, that's not the only explanation. Market positioning can also cause stocks to rally as investors sell the rumor of weaker-than-expected data, and then buy the fact when the data is released.

In the current environment, there are more days when stocks and bonds are positively correlated than not. This increases the likelihood that the 'bad news is good news' dynamic can continue for now. This could benefit stocks as they face potential headwinds from an economy that may soon start to look more recessionary. As you might expect, during recessions, even good news is bad for stocks, and it's best to stay out of the market altogether.

Final Thoughts

The stock market's 'bad news is good news' phenomenon is a complex and fascinating subject. It's a testament to the intricate interplay of economic data, market expectations, and investor behavior. As we navigate these uncertain times, it's crucial to keep a close eye on these dynamics and adjust our strategies accordingly. What are your thoughts on this phenomenon? Do you think it's a reliable indicator of market trends? Share your thoughts and discuss with your friends. And don't forget to sign up for the Daily Briefing, which is delivered every day at 6pm.