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Why stock-market bears are inadvertently supporting a rally despite some bad news

The U.S. stock market has been doing surprisingly well so far in 2023 despite evidence of slowing economic growth, uncertainty about the direction of the Federal Reserve’s monetary policy, troubles in the regional-banking sector, and the politics of the debt ceiling in Congress.

The S&P 500

has advanced 7% year-to-date, while the tech-heavy Nasdaq Composite

has recovered 17.9% so far this year and the Dow Jones Industrial Average

has shed 0.4%, according to FactSet data. 

So why has the stock market failed to drop on bad news?

Tom Essaye, founder of Sevens Report Research, said negative expectations from both institutional and retail investors were “inadvertently supporting stocks” as the market’s failure to decline on bad news prompts buying by investors who are underweight equities.

“That dynamic has largely continued and it’s one of the biggest reasons stocks seemingly can’t drop on negative news,” he wrote in a Tuesday note. 

The dynamic Essaye described is a market concept called the “pain trade” which sometimes occurs when a majority of market participants have positioned themselves in a particular direction, but an unexpected market reversal causes significant losses for those who are caught on the wrong side.

The concept is based on the idea that the stock market has a higher probability of moving in the opposite direction to a prevailing consensus and a tendency to extract the maximum pain from as many investors as possible.

See: Why bears can’t keep the stock market down despite bad news

The S&P 500 index fell to a two year low in October 2022 as investors worried about elevated inflation and aggressive interest-rate hikes from the Federal Reserve. However, even though the broad market index has recovered some ground in 2023 as inflation has eased and the Fed refrained from raising interest rates further in May, the stock market still sees other persistent worries in the rearview mirror.

Over the past year, institutional investors have removed nearly $340 billion in assets from the stock market, while individual investors have pulled nearly $30 billion, according to the S&P Global Market Intelligence. Meanwhile, money market assets have soared to a record high of $5.3 trillion, according to data from the Investment Company Institute. 

Meanwhile, only about one-third of actively-managed mutual funds outperformed the large-cap S&P 500 during the first quarter of 2023, said Essaye, citing data from the Bank of America.

The recovery in the S&P 500 has left investors and many active managers “underinvested and underperforming” the S&P 500, wrote Essaye. 

In this case, the pain trade is for stocks to move higher when a mass of market participants still remain bearish. 

“That’s why the pain trade remains solidly higher and the net result is that the longer the lengthy list of what ‘could’ go wrong ‘doesn’t’ go wrong, the more the pain felt by underinvested and underperforming managers will intensify, and the more upward ‘fuel’ a market rally will have, as these managers chase stocks higher to increase allocations.” 

See: Here’s the big thing holding up the stock market, says Bank of America

As a result, if investors do get material negative news, for example a hard landing for the economy, a bounce back in inflation, another rise in Fed interest rates, or a debt-ceiling breach, then  “none of this sentiment stuff matters — the S&P 500 will drop, and drop hard,” said Essaye.

However, if all the bad things do not materialize, the ability for the stock market to rally remains stronger as it’ll be fueled by traders who are underinvested, setting up the market to jump higher, said Essaye. 

U.S. stocks finished sharply lower on Tuesday as investors weighed data on April retail sales while awaiting another round of debt-ceiling talks between President Biden and Republican policymakers.

This story originally appeared on Marketwatch

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