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Good News is Bad News Again

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Strong economic data sends investors running … the relationship between the 10-year Treasury yield and the S&P … what will drive your portfolio in 2023 … the latest economic data

We’re back to “bad news is good news” and vice versa.

Wall Street hates headlines about a resilient economy and strong labor force, and applauds anything hinting of weakness.

To unpack this and get a sense for what that means for your portfolio, let’s check in with our technical experts John Jagerson and Wade Hansen of Strategic Trader.

They begin their latest analysis by pointing readers toward what they believe holds the fate of the S&P in 2023…

The 10-year Treasury yield.

For newer Digest readers, the 10-year Treasury yield is one of the most important influences on your stock portfolio value

This is for two big reasons:

First, as this yield climbs, the 10-year Treasury bond become a far more attractive investment alternative to stocks for many conversative-minded investors.

For example, this past October, the 10-year Treasury paid investors a 4.2% yield. And if held to maturity, this investment came with zero risk of principal loss (unless the U.S. government implodes).

Compare that to investing in the S&P with its meager 1.74% dividend yield as I write, not to mention the risk of big capital losses as the bear market churns on.

Second, the higher that the 10-year Treasury yield goes, the higher the “risk free” rate that Wall Street uses in its valuation models when it tries to put a fair value on stock prices. In general, the higher this risk-free rate, the lower the forecasted stock price.

To illustrate the relationship between the 10-year Treasury yield (TNX) and the S&P, let’s turn to John and Wade:

…We have seen a direct inverse correlation between the value of the TNX and the value of the S&P 500 (SPX) for the past seven months. When the TNX forms lower highs, the SPX forms higher lows.

That relationship appears to be carrying forward into 2023.

You can see this inverse relationship in the chart below. The 10-year Treasury yield is in black, the S&P is in green.

Chart showing the 10-year treasury yield and the S&P 500 being clearly inversely correlated over the last 7 months

Source: StockCharts.com

Back to John and Wade:

Here’s how the relationship has played out since October…

1. Mid-October
– The TNX jumped to a higher high of 4.3% for the first time since the Financial Crisis in 2008
– The SPX fell to a lower low at 3,500

2. Early November
– The TNX established a lower high at 4.2%
– The SPX established a higher low at 3,700

3. Now (Early January)
– The TNX has hit resistance at 3.9% and has pulled back to 3.7%
– The SPX has found support at 3,800 and is climbing back above 3,854.90

So, where will the 10-year yield – and by extension, the S&P – go from here?

John and Wade believe it boils down to Wall Street’s expectations for the Fed’s policy here in 2023.

If Wall Street begins to anticipate more interest-rate hikes this year, we’ll likely see the 10-year yield climb, which will weigh on the S&P.

But if Wall Street believes fewer interest-rate hikes are coming, the 10-year yield will fall, paving the way for a rally in the S&P.

That points us toward the logical follow-up question: What will impact Wall Street’s expectations for the direction of the 10-year yield?

Back to John and Wade:

Economic announcements.

If Wall Street see signs the U.S. economy is contracting, they will expect fewer rate hikes from the Fed because signs of economic contraction are an indication the rate hikes that have already been made are having the desired effect.

If Wall Street see signs the U.S. economy is expanding (or at least not contracting), they will expect more rate hikes from the Fed because signs of economic expansion are an indication the rate hikes that have already been made are not having the desired effect.

And this bring us full circle to “bad news is good news” and vice versa.

Encouraging data about the economy is now bad news for stocks because it means the Fed will remain aggressive with rate hikes – which impacts the 10-year Treasury yield, and therefore, your stock values.

We saw this dynamic play out yesterday with the surprisingly strong ADP jobs report

Let’s go to CNBC for what happened:

The jobs market closed out 2022 on a high note, with companies adding far more positions than expected in December, payroll processing firm ADP reported Thursday.

Private payrolls rose by 235,000 for the month, well ahead of the 153,000 Dow Jones estimate and the 127,000 initially reported for November.

True to form, the S&P tanked yesterday, dropping 1.2% as investors feared that strong jobs numbers would push the Fed to keep raising interest rates.

In their Strategic Trader update on Wednesday, John and Wade pointed toward two additional recent reports that offer conflicting clues about economic health:

So far this week, we’re getting mixed messages.

The ISM Manufacturing PMI (Purchasing Managers’ Index) number came in at 48.4, which was a positive sign for the SPX.

(Note: The PMI is a diffusion index. Any number > 50 indicates economic expansion, and any number < 50 indicates economic contraction.)

However, the JOLTS Job Openings came in at 10.46 million instead of the anticipated 10.04 million. This was a negative sign for the SPX.

Seeing higher-than-expected job openings indicates a tight labor market, which means wages (and therefore inflation) are likely to continue seeing upward price pressure.

John and Wade also highlighted the minutes from the December Fed meeting, which we commented on in yesterday’s Digest.

In short, the commentary was hawkish, revealing that members appear reluctant to ease monetary policy soon.

This morning, we received three pieces of economic data

We learned the latest numbers on the non-farm employment change, the average hourly earnings, and the ISM Service PMI.

Non-farm payrolls came in hotter than expected, climbing 223,000 compared to expectations of just 200,000. Not great news.

But on the average hourly earnings front, the data were encouraging. Here’s CNBC:

Wage growth was less than expected in an indication that inflation pressures could be weakening.

Average hourly earnings rose 0.3% for the month and increased 4.6% from a year ago. The respective estimates were for growth of 0.4% and 5%.

This is good news, as the Fed has been very nervous about wage increases.

Finally, the ISM Service PMI showed a contraction for the first time in more than two-and-a-half years thanks to weakening demand. The report also showed that prices paid by businesses slowed substantially, another piece of data suggesting inflation is cooling.

This PMI report isn’t great news for the economy, but that means it’s wonderful news to Wall Street who wants to see weakness.

And in fact, as I write Friday morning, all three major indexes are up well over 1%. Wall Street appears to be applauding the “softening economy/cooling inflation” aspect of these reports.

Here’s John and Wade’s bottom line to take us out today:

If the labor market continues to strengthen, it could put a damper on any bullish movement in the SPX.

But if we see some softening, that could clear the way for stocks to move higher.

Have a good evening,

Jeff Remsburg