Why Good News Was Bad News for the Market

Read Scott Horton's new book Fool's Errand: Time to End the War in Afghanistan

Over the last two trading days (2/2 and 2/5), the Dow Jones Industrial Average has lost more than 1,800 points, or about 7%.

Meanwhile, the S&P has lost 173 points, or more than 6%.

These sharp downward moves have many people looking for an explanation. No big companies failed. No wars were started. No new policies were enacted. So why did the market lose nearly 7% of its value in two days?

Part of the answer is this: a better-than-expected jobs report.

That is, the markets received positive news on the US labor market, indicating that the US economy appears to be in good health. In response, stocks sold off.

On the surface, this sequence of events appears absurd.

If the economy is doing well, that should be a positive indicator for US companies and US stocks. After all, a positive jobs report would suggest that companies are optimistic about the future and expanding their operations by hiring more people. In turn, we’d expect these new investments to eventually bear fruit in the form of higher profits. If anything, stocks should go up after a positive jobs report.

And in a truly free market, that’s probably how things would work.

However, in the markets we actually have, this intuition gets turned on its head.

Good News Is Bad News

Today’s stock market is influenced dramatically by the actions of the US central bank, the Federal Reserve.

While not technically part of the US government, the Federal Reserve is not a creature of the free market. Instead, it is a quasi-governmental body that is responsible for centrally planning interest rates–arguably the most important “price” in the economy.

All else equal, when the Fed raises interest rates, stocks tend to go down and vice versa.

This relationship, and the outsized influence of the Fed, is the key to understanding why the market behaved like it did.

The better-than-expected jobs report really was good news for the economy. The problem was that this good news made it even more likely than before that the Federal Reserve would continue on its current path of hiking interest rates and reducing its balance sheet. Indeed, it could even accelerate the interest rate hikes. This is a big part of what spooked the markets.

In other words, there are two questions we need to consider when we get new data on the economy:

  • What does this data say about the economy?
  • How will the Fed react to it?

Of the two, the second question is far more important.

Stocks have soared to record highs on the back of nearly a decade of ultra-low interest rates from the Fed. Now that the Fed appears committed to bringing interest rates back to more normal levels, investors are taking notice.

That’s why good news was bad news for stock prices.

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Read Scott Horton's new book Fool's Errand: Time to End the War in Afghanistan

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