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The stock market paradox, where bad news about the economy is seen as good news for stocks, may be playing out. If so, investors should expect bad news to be bad news for stocks heading into the new year, and there could be a lot of it.

But first, why would good news be bad news? Investors have largely focused 2022 on the Federal Reserve and a rapid series of big rate hikes aimed at fueling inflation. Economic news pointing to slower growth and less fuel for inflation could help stocks rise on the idea that the Fed may begin to slow pace or even entertain future rate cuts.

Conversely, good news about the economy can be bad news for stocks.

So what has changed? Last week saw a softer-than-expected consumer price index reading for November. While still very hot, with prices rising more than 7% year-on-year, investors are increasingly confident that inflation may have peaked in roughly four decades, above 9% in June.

See. Why November’s CPI data is seen as a “game changer” for financial markets

But the Federal Reserve and other major central banks have indicated they intend to continue raising interest rates, albeit at a slower pace, through 2023 and likely to hold them longer than investors expected. That raises fears that a recession is becoming more likely.

Meanwhile, markets are behaving as if the worst of the inflation scare is in the rearview mirror, with fears of a recession now on the horizon, said Jim Baird, chief investment officer at Plante Moran Financial Advisors.

That sentiment was bolstered by manufacturing data on Wednesday and weaker-than-expected retail sales on Thursday, Baird said in a telephone interview.

Markets are “probably going back to a period where bad news is bad news not because interest rates will be a concern for investors, but because earnings growth will weaken,” Baird said.

“Reverse Fruit Trade”

Keith Lerner, Truist’s co-chief investment officer, argued that a mirror image of the backdrop inspired by hedge fund titan David Tepper in September 2010 that created what became known as the “Tepper trade” could be forming.

Unfortunately, while Tepper’s cautionary call was about a “win/win scenario.” A “reverse Tepper trade” is shaping up to be a lose/lose proposition, Lerner said in a note on Friday.

Tepper’s argument was that the economy would either improve, which would be positive for stocks and asset prices. Or, the economy will weaken as the Fed acts to support the market, which will also be positive for asset prices.

The current structure is one where the economy is set to weaken, curbing inflation but also reducing corporate profits and challenging asset prices, Lerner said. Or, instead, the economy remains strong, along with inflation, as the Fed and other central banks continue to tighten policy and challenge asset prices.

“In both cases, there is a potential headwind for investors. To be fair, there is a third way in which inflation declines and the economy avoids recession, the so-called soft landing. It’s possible,” Lerner wrote, but noted that the path to a soft landing is looking increasingly narrow.

The tremors of the recession were on display Thursday when November retail sales showed a 0.6% drop, beating forecasts for a 0.3% drop and the biggest drop in nearly a year. Also, the Philadelphia Fed’s manufacturing index rose but remained in negative territory, disappointing expectations, while the New York Fed’s Empire State index fell.

Stocks, which had moderated losses since the Fed raised interest rates by half a percentage point a day earlier, fell sharply. Stocks extended their slide on Friday with the S&P 500 SPX,
-1.11%
recording a weekly loss of 2.1%, while the Dow Jones Industrial Average DJIA,
-0.85%
fell 1.7%, and the Nasdaq Composite COMP,
-0.97%
decreased by 2.7%.

Read: Still a bear market. S&P 500 decline signals stocks never hit ‘escape velocity’

“As we move into 2023, economic data will have a bigger impact on stocks because the data will tell us the answer to a very important question: How much worse will the economic slowdown get? That’s the key question as we head into the new year, with the Fed’s policy autopilot (more hikes from 2023) key now being growth and the potential damage from a slowdown,” said Tom Essay, founder. Sevens Report Research in Friday’s post.

Recession watch

No one can say with absolute certainty that a recession will happen in 2023, but there seems little doubt that corporate earnings will come under pressure and that will be the main driver of markets, said Plante Moran’s Baird. And that means earnings could be a significant source of volatility in the year ahead.

“If the story in 2022 was about inflation and pace, for 2023 it will be earnings and recession risk,” he said.

It’s no longer an environment that favors high-growth, high-risk stocks, while cyclical factors may be shaping up well for value-based stocks and small caps, he said.

Truist’s Lerner said that until the weight of evidence changes, “we maintain our overweight in fixed income, where we are focused on high-quality bonds and relatively underweight in equities.”

In stocks, Truist favors the U.S., a value tilt and sees “better opportunities below the market surface,” such as the equal-weighted S&P 500, which is a proxy for the average stock.

Highlights on the economic calendar for the coming week include Thursday’s revision of third-quarter gross domestic product as well as the November reading of leading economic indicators. Personal consumption and spending data, including the Fed’s preferred gauge of inflation, will be released on Friday in November.

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