Equity sentiment is positive despite the bad headlines

New York
CNN
—

It’s only early January, but so far in 2023, the pendulum on Wall Street has swung (to paraphrase Billy Joel) from sadness to euphoria.

Equities are off to a solid start after last year’s dismal performance. Even though the Dow fell more than 110 points, or 0.3%, to close out Monday’s session, it’s still up more than 1% this year. The S&P 500 ended 0.1% lower on Monday, while the Nasdaq gained 0.6%. But those two indices are each up about 1.5% since the end of 2022.

Even the CNN Business Fear and Greed Index, which looks at seven indicators of market sentiment, is now moving closer to greed territory after languishing in fear mode for most of the past few weeks.

But why is there all of a sudden such optimism on Wall Street? The headlines are still not necessarily that great.

Yes, the market applauded Friday’s jobs report as it showed slowing wage growth that could lead to a further reduction in inflationary pressures and smaller rate hikes by the Federal Reserve. But it also showed that the pace of job growth is slowing and that could be a harbinger of an eventual recession.

Meanwhile, the latest data from the Institute for Supply Management showed that the service sector, a major driver of the US economy, contracted last month. And several high-profile companies in the technology, consumer, financial services (and yes, media) industries have announced major layoffs or unveiled plans to hand out pink slips. Retailers like Macys

(M) and Lululemon

(LULU) warn about turnover and profit.

Add all this together and it doesn’t sound like cause for celebration.

But Wall Street is a funny place: good news is often seen as a bad sign, and vice versa.

Of course, it would be a big plus if the Fed were able to deliver a proverbial soft landing, slowing down the economy without leading to a full-blown recession and/or a significant drop in corporate earnings. But that’s a big if.

There is another possibility that bulls are clinging to: that a recession is coming, but a mild recession that also happens to be one of the most anticipated and telegraphed downturns in recent history. This is not a proverbial black swan. There is no Lehman moment to catch everyone off guard.

As long as the Fed can get inflation under control, investors may not worry too much about a recession. At least, that’s the glass half full argument.

Any recession will be perceived as less of a problem by investors if inflation is judged to be sufficiently contained and the Fed is prepared to provide an appropriate monetary response, Robert Teeter, general manager of Silvercrest Asset Management, said in a report.

Teeter added that falling inflation should boost stocks this year, even as earnings remain subdued.

But others see a problem with that argument.

Our concern is that the most [investors] assume everyone is bearish, and therefore price decline in a recession is likely to be mild as well, Morgan Stanley strategists said in a report.

Instead, Morgan Stanley strategists think investors will be surprised by how much lower stocks go when a recession hits. They noted that the market may not be pricing in much weaker gains.

Investors may also be underestimating how far the Fed is willing to go with rate hikes to ensure that inflation finally starts to come down.

Many investors are reassured by the strength of the US labor market. Still, the Federal Reserve is determined to tighten monetary policy until that force is eradicated. The recession clock is ticking, Seema Shah, chief strategist at Principal Asset Management, said in a report.

And Shah doesn’t believe the recession will be mild. She wrote after Friday’s jobs report that a hard landing seems the most likely outcome this year.