When jobs data disappoints, most investors brace for trouble. Robert Rapier explains today why the same soft data can be a genuine tailwind for income-producing stocks — specifically the utilities and dividend payers that benefit most when the Fed signals it’s done tightening. — The Editors of Investing Daily

See how Robert has positioned his portfolio for exactly this setup →

One of the strangest things about investing is watching the stock market celebrate bad economic news.

We got another example last week. The Labor Department reported that the U.S. economy lost 23,000 jobs in July, far worse than the roughly 80,000-job increase economists had expected. Job gains for May and June were also revised downward by a combined 103,000. On the surface, none of that sounds like a reason to buy stocks.

Yet investors did exactly that.

The S&P 500 rallied to a record closing high, and Treasury yields fell. The explanation was simple: The weak employment report reduced expectations that the Federal Reserve would raise interest rates at its September meeting. Markets had suddenly decided that bad news for the economy might be good news for interest rates.

This phenomenon can seem irrational until you understand what the market is actually pricing.

The Market Is Looking Ahead

Stock prices don’t simply reflect how the economy is performing today. They represent investors’ expectations about corporate profits, interest rates, inflation, and economic conditions months or even years into the future.

That’s why the market can sometimes react to economic news in ways that seem backward.

Suppose the economy is growing rapidly, unemployment is falling, and wages are rising. Ordinarily, those would all be considered good news. But if inflation is already running too high, strong economic data can convince investors that the Federal Reserve will raise interest rates or keep them elevated longer.

Higher rates affect stocks in several ways. They increase borrowing costs for businesses and consumers. They can slow economic activity. They also make bonds and other fixed-income investments more competitive with stocks.

Perhaps most importantly, higher interest rates reduce the present value investors are willing to pay for future corporate earnings. This effect can be particularly pronounced for expensive growth stocks whose valuations depend heavily on profits expected many years from now.

Under those circumstances, a surprisingly strong jobs report can actually send stocks lower.

Reverse the situation and you get what happened Friday.

Why Weak Data Can Help Stocks

When economic data begin to soften, investors may conclude that the Federal Reserve no longer needs to be as aggressive.

That can lead to lower Treasury yields and expectations for lower future interest rates. Lower rates reduce borrowing costs, support economic activity, and make stocks relatively more attractive compared with bonds.

This can be especially helpful for rate-sensitive investments such as utilities, real estate investment trusts, and other dividend-paying stocks. Many of these companies carry substantial debt, so lower borrowing costs can directly improve their financial outlook.

Bond investors can benefit as well. When market interest rates decline, the prices of existing bonds with higher yields generally rise.

So there really are circumstances in which weaker economic data can produce better market returns.

But there is a catch.

There Is a Limit to “Bad News Is Good News”

Markets don’t actually want a bad economy.

What investors often want is an economy that is just weak enough to bring inflation and interest rates down without falling into recession.

That distinction is crucial.

Imagine employment growth slowing from 200,000 jobs a month to 100,000. Investors might welcome that because it reduces wage and inflation pressure without necessarily threatening consumer spending or corporate profits.

But suppose the economy then begins losing hundreds of thousands of jobs every month. Consumers pull back sharply, businesses reduce investment, loan defaults rise, and corporate earnings plunge.

At that point, lower interest rates aren’t enough to offset the damage. Bad economic news becomes exactly what it sounds like: bad news.

That’s why Wall Street spends so much time debating the possibility of a “soft landing.” The ideal outcome is for inflation to decline and the economy to cool sufficiently for the Fed to ease monetary policy, while avoiding a serious recession.

It’s a narrow path.

Friday’s employment report moved investors toward the view that the Fed may have less reason to raise rates. Markets cut the implied probability of a September increase to less than 50%. But the report also contained some genuinely concerning information. The economy lost jobs, previous months were revised lower, and the labor-force participation rate fell to its lowest level in more than five years.

If that weakness continues, investors may eventually stop cheering.

Inflation Complicates the Picture

There is another wrinkle in the current environment. Normally, a weakening labor market would give the Fed substantial room to reduce interest rates.

But inflation remains well above the central bank’s 2% target.

That creates competing risks. Raise rates too aggressively and the Fed could worsen the slowdown in employment. Leave rates too low and inflation could remain elevated or accelerate again.

This is why individual economic reports can produce such dramatic market reactions. Investors are constantly recalculating which risk the Fed is likely to emphasize.

For example, after Friday’s weak jobs report, attention immediately shifted to the next inflation report. If inflation continues cooling, the combination of softer employment and lower inflation would make a less restrictive Fed policy easier to justify. If inflation surprises to the upside, the Fed faces a much more difficult decision.

What Investors Should Take From This

The lesson isn’t that you should buy stocks every time economic news is bad.

Instead, understand the context.

Ask what the economic report means for inflation, interest rates, corporate earnings, and Federal Reserve policy. A weak jobs number during an overheating economy can be welcome news. The identical number during a recession could be alarming.

The same principle works in reverse. Strong economic growth is generally desirable, but if the economy is already straining against capacity and inflation is rising, another burst of growth may lead investors to anticipate tighter monetary policy.

This is also why I don’t put much faith in attempts to trade every economic report. Markets are forward-looking, and they react not just to whether a number is good or bad, but to how it compares with expectations and what it implies about everything that comes next.

Sometimes good economic news is good for stocks.

Sometimes bad economic news is good for stocks.

And sometimes bad news is simply bad.

The trick is understanding which environment you’re in.

The interest-rate dynamic I described above plays out most directly in the essential-service companies I follow in Utility Forecaster. Utilities and pipelines carry real debt — and when the Fed signals lower rates, the math on their borrowing costs, dividends, and earnings gets better. At the same time, these businesses serve mandated demand; people pay their power and water bills in any economic environment. That’s why I look for safety, income, and growth in the same position rather than trading one off against another. If you’d like to see which companies I’m holding right now and what’s on my current Best Buys list, those details are here.

Get Robert’s full Utility Forecaster portfolio and Best Buys list →