The "bad news = good news" theory is gradually collapsing, and US stock trading is returning to a classic framework: driven by performance and the economy

For Wall Street economists who have long adhered to the "economic growth bull market" view, they are increasingly inclined to reissue new research reports to reverse their views. The unsettling data in the bond and commodity markets have awakened traders of risky assets such as the stock market from their slumber this week, marking the worst performance of the U.S. stock market since the Silicon Valley Bank Crisis of 2023. Suddenly, Wall Street traders are focusing on the future economic risks of the United States.

The theory of "bad news is good news" has long been one of the catalysts driving the valuation of U.S. stocks higher—meaning that a sluggish U.S. economy implies that the Federal Reserve will be more aggressive in cutting interest rates, thereby benefiting the trend of U.S. stocks and other risky assets. However, recently, this theory can be said to have "collapsed", as the market is once again embracing the "classic framework" that drives the rise of U.S. stocks, namely strong performance and robust macroeconomic conditions, rather than "bad news is good news".

The July unemployment rate data that triggered the "Sam Rule" can be seen as the beginning of the failure of the "bad news is good news" trend. Since then, the catalysts for the rise of U.S. stocks no longer rely on rate cuts driven by weak economic data, but more on robust macroeconomic data and strong performance. The emergence of persistently weak economic data not only indicates a slowdown in the U.S. economy, but also increases the possibility of a recession, which would have a devastating impact on the valuation of the entire U.S. stock market due to the sharp drop in consumer spending, significant cuts in corporate spending, and massive layoffs.

In contrast, the most obvious is the continuous hovering around or slightly above expectations of initial jobless claims data since early August, which has continued to dampen expectations of a 50 basis point aggressive rate cut, while also dampening expectations of a recession. However, U.S. stocks have shown an upward trend during this period.

Performance is also a key catalyst for the recent rise in U.S. stocks. Disappointing performances from tech giants like Google, Microsoft, and Tesla, as well as the unclear prospects of AI monetization, have all led to significant declines in their stock prices, weakening the S&P 500 index due to their high weightings. However, investors are not completely abandoning AI-related tech stocks, but are focusing on finding companies that can achieve performance growth numbers through breakthrough generative AI. For example, German software giant SAP, AI software pioneer Palantir, and veteran tech giant IBM, as well as Meta, the parent company of Facebook, have all experienced rapid surges in their stock prices in the short term after announcing stronger-than-expected quarterly performance and outlook.

However, after the weaker-than-expected non-farm payroll data in August, although expectations of a 50 basis point aggressive rate cut have increased, the recession expectations have also risen, leading to another significant drop in U.S. stocks. Moreover, most of the economic data released since September implies that the U.S. economy is getting closer to a recession, even pushing the S&P 500 index to its worst weekly performance since March of last year this week.

This is why, compared to a 50 basis point rate cut, the market is more willing to see the Fed, which has already signaled a rate cut, choose to cut rates by 25 basis points in September. If the Fed chooses a 25 basis point rate cut in September, it is basically equivalent to a "preventive rate cut", meaning that the Fed's outlook for the U.S. economy is relatively optimistic, and the 25 basis point rate cut is more about preventing the U.S. economy from entering a recession and striving to contribute to the momentum of the U.S. economy; A 50 basis point rate cut largely implies that the Federal Reserve is relatively pessimistic about the U.S. economy - that is, Fed officials may see signs of an economic downturn that the market has not noticed, increasing the possibility of a self-fulfilling economic recession. At the same time, it also means that the Fed's rate cut may not be equivalent to "preventive rate cuts", and the stock market may fall into panic selling due to the surge in recession expectations.

Wall Street traders increasingly succumb to growth concerns

After a rapid rebound from the lows in early August, Wall Street traders succumbed to concerns about economic growth due to recent discouraging economic data, particularly in the labor market and extremely weak ISM manufacturing data. The S&P 500 index fell for four consecutive days, credit spreads widened at the fastest pace since early August, the Philadelphia Semiconductor Index plummeted by 12%, marking the largest weekly decline since the outbreak of the COVID-19 pandemic.

Despite this year's benchmark index, the S&P 500, still rising by 13%, almost all fluctuations in the bullish chart are short-lived. Risk-sensitive assets are still largely seen as heading for a "soft landing" of the U.S. economy rather than a recession.

However, this kind of trading behavior - especially Friday's trading behavior - is a rare consensus among cross-asset investors. According to an indicator, until recently, their divergence on the future of the U.S. economy reached the most severe level since 2019, making the consensus reached on Friday truly rare.

With the impact of over two years of hawkish policy actions by the Federal Reserve, the U.S. stock market this week joined a longer-lasting market decline due to some economically sensitive retailers (such as Dollar Tree) and some weak economic data. However, the significant drag effect of soft economic data such as non-farm payrolls and manufacturing has tormented oil prices, copper prices, and bond yields for over a month.

"Investors may now be aware of the risks of an economic recession, but that's after hitting the snooze button ten times," said Michael O'Rourke, Chief Market Strategist at JonesTrading. " When you consider economic data and subsequent earnings reports, the environment may only deteriorate."

While the stock market plays music, the bond market has long sounded the alarm

Bond investors - whether right or wrong, they have always been seen as "smart money" because they tend to anticipate changes in the economic direction ahead of time. They bet that the Fed's rate cut pace will be faster than the general expectation on Wall Street. This has also pushed the 2-year U.S. Treasury yield to its lowest level since 2022, indicating that bond investors expect the U.S. economy to deteriorate further, prompting the Fed to continue cutting rates by 50 basis points The comprehensive commodity complex also sends warning signals about the prospects of consumption and investment cycles, with two major commodity indicators of global growth experiencing significant declines - oil prices have erased all gains from 2024, while copper prices have fallen in 13 out of the past 16 weeks.

Although the U.S. stock market embarked on a completely different bull market path in 2024 under the catalysis of "bad news is good news", the trend this week does have a clear omen: in early August, early signs of a weak labor market led to a sharp drop in bond yields and stocks, and this volatility storm came and went quickly. The recent outbreak reflects the same concerns that led to the first crash - the U.S. economy may be rapidly stagnating, the Federal Reserve cannot boost the economy with "precautionary rate cuts", and there are no emergency policies in place to remedy the situation in time.

From a certain perspective, the simultaneous selling of risky assets such as stocks confirms a particularly cautious attitude in government bonds. To understand how the pricing of stocks and credit differs from other assets in an optimistic growth scenario, one can refer to models compiled by strategists at JPMorgan Chase, including Nicholas Panigirtzoglou. By comparing the trends of various assets with past cycles, the model derives the likelihood of an economic recession from the trends and pricing of various asset classes. The model shows that as of Wednesday, the probability of an economic recession implied by the stock market and investment-grade credit is relatively low, at only 9%.

In contrast, the pricing of commodities and the U.S. bond market implies a much higher probability of recession, around 62% and 70% respectively.

Priya Misra, portfolio manager at J.P. Morgan Asset Management, said, " I don't think any market is really considering the reasonable possibility of an economic recession, but overall data suggests that the risk of an economic recession is increasing." "Although it is difficult to judge whether the Fed will cut rates by 25 basis points or 50 basis points in September, if an economic recession is imminent, all markets will have significant movements, not just focusing on the pace of Fed rate cuts. And the penetration of rate cuts into the economy also takes time."

The probability of recession in different asset categories is diverging - the probability of recession priced in the stock market is much lower than that priced in U.S. bonds

Of course, in most eras, extracting clean economic information from the noisy financial assets is also full of risks. Throughout the inflation era, markets and central bankers repeatedly made incorrect predictions about the business cycle. At the same time, a large number of investment factors such as trader sentiment and fund flows may drive prices beyond the reasonable levels represented by macro fundamentals. For example, the recent logic behind the pullback in the U.S. stock market includes not only recession concerns, but also crowded positions and overvaluation, especially in large tech stocks such as NVIDIA, Google, and Microsoft.

Perhaps the bond market is too pessimistic? The probability of a slowdown in the U.S. economy is high, but it may not necessarily fall into a substantial recession

Last month, the emotional gap between stocks and bonds was still evident. The equal-weight version of the S&P 500 Index - giving large tech companies the same weight as ordinary consumer goods - hit a historic high at the end of August, signaling optimism for the future business cycle. At the same time, the yield on the two-year U.S. Treasury bonds continued to decline, reflecting the market's anticipation that the Federal Reserve led by Powell will be forced to cut interest rates faster than expected to boost the weak U.S. economy, showing a stark difference in the market's judgment and pricing of the macro economy between stocks and bonds.

If this belief is established, risky assets such as stocks may be forced to seek new clues from the world's most important bond market. However, this is not a perfect science, but in the early part of this week, the S&P 500 Index was only 2.5% away from its 52-week high for three consecutive trading days, while the 2-year U.S. bonds fluctuated around 50 basis points near the 52-week low, a stock-bond differentiation phenomenon unseen since 2019.

Throughout the entire stock market bull market period, especially in this post-pandemic era, any predictions of an economic recession have been proven wrong. The bond market is not always right either. Until this week, the yield on the 2-year U.S. Treasury bonds has been higher than the 10-year Treasury yield since 2022, marking the longest period of inversion in history.

Now, as the shape of the yield curve normalizes for the first time in this market cycle, people are beginning to question whether it is the most reliable indicator of an economic recession.

Historically, signals from the data have always been ominous, with the last four economic recessions starting after the yield curve turned positive again. However, with the Fed cutting rates, a successful "soft landing" for the U.S. economy may also stimulate a steeper yield curve, pushing short-term yields down.

Jim Reid, a strategist at Deutsche Bank, wrote in a report this week: "Therefore, regardless of which way you lean, a positively sloped curve (if we continue in this direction) could bring a key moment, whether the yield curve has completely lost its ability as a leading indicator of this cycle, or whether the power it brings this time is later than in other historical cycles."

For Nathan Thooft, a fund manager at Manulife Asset Management managing $160 billion in assets, a slowdown is inevitable, but the U.S. economy will be able to avoid a "substantial recession." However, this has not stopped his company from reducing its stock holdings in recent weeks, as he believes that even a slowdown will lead to a decline in U.S. stock valuations. "This is not due to concerns about a significant downturn in the U.S. economy, but due to technical and bullish sentiment weakening due to signs of economic weakness, overvaluation, election, and seasonal factors."