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Why do stocks react badly to good news?

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Credit Sesame on why stocks react badly to good news about job growth.

On February 3, 2023, the Bureau of Labor Statistics (BLS) released its monthly Employment Situation report for January. It was terrific news. Better than expected. Right away, the stock market went into a funk.

This kind of market behavior may seem puzzling. The fact that stocks react badly to good news only makes sense when you realize that the stock market and the economy are two different things.

A blockbuster jobs report stokes inflation fears

The BLS report showed that the economy added 517,000 jobs in January 2023. It was the best month for job growth since July 2023 and halted a streak of five consecutive months of declining employment gains. It also decreased the unemployment rate to 3.4%, the lowest since the late 1960s. 

Sounds like great news. In particular, robust job growth and a very low unemployment rate are welcome at a time when recession fears have become widespread. 

January’s huge job growth might seem like the perfect antidote to the mass layoffs announced during the month by some of the biggest names in the tech sector. 

Yet, the stock market lost 1% on the same Friday the employment report came out, and the slide continued the following Monday.

Perhaps counterintuitively, investors may have started yelling “sell!” because the job report was too good. 

Coming at a time when the economy has been plagued by high inflation for two years, a fresh hiring binge threatens to fuel that fire. This is because demand for labor exceeds the supply. 

Supply and demand strikes again

Economists normally use goods when explaining how the relationship between supply and demand affects prices. If there’s a surge in demand for new cars that the supply of vehicles cannot keep up with, you expect prices to go up.

It’s the same with labor, only in this case the price is the wage employers have to pay their workers. When companies have trouble finding people to fill all the jobs they have open, they start offering higher wages to attract applicants. 

As of the end of 2022, there were two job openings for every person looking for work. That indicates much more demand for labor than there is supply. This was before January’s high job growth.

Labor in short supply may force employers to offer higher wages. That’s great for workers, but it also means that companies pass that higher cost onto consumers. In turn, this translates to more price increases that could give inflation a boost just when the Federal Reserve has struggled to get it under control.

Higher interest rates cut stock values

The Fed has tried to calm inflation by raising interest rates. When inflation eased over the second half of 2022, investors hoped that the Fed was nearing the end of its rate increases. There was even speculation that the Fed might start cutting rates before the end of 2023. 

January’s jobs report threw cold water on those hopes and revived the inflation threat. But why this would send stock prices lower? It helps to understand how investors decide on a stock’s value. 

When investors buy stocks, they generally look ahead to the money that the company may earn over the next several years. They expect those future earnings to represent more of a return than they could get by investing in something safe like a Treasury bond. 

The higher bond interest rates go the more earning potential a stock must have to be worth the risk of investing in it. If stocks do not appear to have a better return than bonds, investors steer clear of the stock until prices drop. The price has to drop enough for the potential earnings to yield a better return than from bonds.

In short, when interest rates rise, stocks react badly and their value goes down. 

Rate fear goes beyond the Fed

Much of the discussion of rising interest rates focuses on decisions by the Fed. However, the Fed is only responding to inflation.

The Fed raises rates when inflation is too high. The hope is that making borrowing more expensive cools off economic demand. In theory, less demand means lower inflation.

Inflation forces the Fed to raise rates but interest rates tend to rise in inflationary times, anyway. This is because lenders make loans at rates that at the very least keep up with inflation. If they lend at an interest rate lower than inflation, the money they get back is worth less than the value of the money they lent.

Higher inflation pushes interest rates higher making stocks less valuable. This is one reason why the stock market is sensitive to inflation.

Rapid price increases create uncertainty for businesses. Managers have to figure out how much to raise prices to stay ahead of cost increases. However, if they raise prices too much, they run the risk of stifling consumer demand or losing market share to competitors. 

When inflation is fairly stable, managers can make more informed decisions about pricing. When inflation is changing quickly, it makes pricing decisions more uncertain. This raises the risk to company earnings. 

The stock market vs. the economy

A hot job market may be good news for the economy in general, but it comes with consequences for stock investors. 

More inflation pressure pushes interest rates higher. This dampens stock valuations.

Meanwhile, fast-rising costs may squeeze corporate profits and force pricing decisions that can hurt sales. This threat to company earnings also makes stocks less attractive. 

The January jobs report means this is a great time to be looking for a job or seeking a raise. At the same time, it underscores that this remains a risky environment for stocks. 

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Disclaimer: The article and information provided here is for informational purposes only and is not intended as a substitute for professional advice.

Richard Barrington
Financial analyst for Credit Sesame, Richard Barrington earned his Chartered Financial Analyst designation and worked for over thirty years in the financial industry. He graduated from St. John Fisher College and joined Manning & Napier Advisors. He worked his way up to become head of marketing and client service, an owner of the firm and a member of its governing executive committee. He left the investment business in 2006 to become a financial analyst and commentator with a focus on the impact of the economy on personal finances. In that role he has appeared on Fox Business News and NPR, and has been quoted by the Wall Street Journal, the New York Times, USA Today, CNBC and many other publications.

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