• For a couple of years, stocks have largely had an inverse relationship with economic data. The better the numbers, the worse the market has performed.
• It may take a while for good news to become good again.

For a couple of years, stocks have largely had an inverse relationship with economic data. The better the numbers have been — whether weekly jobless claims, consumer sentiment or housing starts — the worse the market has performed and vice versa.

The phenomenon showed up last month when manufacturing, services and employment data all undershot expectations within days of one another. That batch of bad news caused bond yields to plummet, and stocks responded by notching their longest winning streak in two years.

It all begs the question: When does good news become good again and bad news bad?

The short answer is that it may take a while.

Markets may cheer 'slow trickle of slightly bad news'

Indeed, inflation remains elevated, and while there's been speculation about when the Fed will pivot, most policymakers are committed, at least publicly, to keeping rates "higher for longer."

Therefore, markets are likely to welcome a slow trickle of slightly bad news in the weeks to come. That will prevent the Fed from hiking rates further, likely prompting additional declines in bond yields, allowing stocks to continue to rally, with utilities and other bond proxies potentially doing well. The same goes for defensive groups like consumer staples and healthcare companies. 

Nevertheless, bond yields getting too low is a problem because that would mean that the economic data is beginning to suggest that difficult-to-resolve challenges are right around the corner. All of this helps to explain why it's tough to distinguish between a healthy slowdown (i.e., soft landing) and the initial stages of a recession — and why the next few job reports will be so significant.

The economy added about 150,000 jobs in October, a profound slowdown over the previous month. Nonetheless, investors cheered the report, believing it gave the Fed the ammunition it needed to hold off on further rate increases.

ETFs, small caps can offer buying opportunities

A more meaningful slowdown in new jobs over the coming months — 50,000 or below — would likely flip the bad-news-is-good-news script. Deep cyclical stocks that pay generous dividends would be attractive in such a scenario. But so would small caps.

In 2023, small, publicly listed companies have greatly underperformed, with the Russell 2000 lagging the S&P 500 by 13% year to date. The fact that small companies have struggled this year relative to the rest of the market is hardly surprising.  

Such firms tend to rely on floating-rate debt more than their larger peers, so their margins shrink when Fed policy is more restrictive. Complicating matters further are rising labor costs.

If the job market took a turn for the worse, many small caps — especially cyclically sensitive ones — would crater, eventually creating an attractive buying opportunity. The key would be to move before policymakers do because the market will have already reacted by the time the Fed officially pivots.  

The problem with small caps, however, is volatility: The ups and downs of smaller companies are more frequent and pronounced. That's why it isn't easy to feel good about taking individual positions in this segment of the market.

The alternative is to gain exposure via exchange-traded funds. One option is the iShares Russell 2000 ETF (IWM). Another fund that may underperform during a slowdown or recession but jump during the early stages of a recovery is the iShares Russell Mid-Cap Value ETF (IWS). 

Today's bad-news-is-good-news dynamic might seem unique, but it isn't. As with most things with the markets, it's cyclical.

The good news is that a soft landing can happen if core inflation continues to trend toward the Fed's 2% target and payroll growth remains positive. Yet those are far from sure things.

Indeed, if job creation comes to a screeching halt instead, look for small caps and deep cyclicals to suffer losses. At the same time, they could lead the markets higher during the initial bounce back. 

— Andrew Graham, founder and managing partner of Jackson Square Capital