"Good news" becomes "bad news": The more US economic data exceeds expectations, the more the S&P 500 falls.

The US economy continues to outperform expectations, yet it has not provided new upward momentum for US stocks.

The latest research from market research and asset management firm Leuthold Group finds that when economic data is strong enough, the market focus often quickly shifts from corporate earnings and fundamentals to the outlook for Federal Reserve policy. The trading logic of "good news is bad news" begins to dominate—the stronger the economy, the harder it is for inflation pressures to subside, and the less incentive the Fed has to ease its policies, thus suppressing stock valuations.

This pattern is replaying in the current market. Recently, US employment, retail sales, and regional manufacturing data have repeatedly exceeded expectations, with the Citi US Economic Surprise Index (CESI) remaining above 50, reaching 63 in June, the highest since 2023. However, US stocks have not gained new upward momentum due to economic resilience, instead continuing to be turbulent as investors begin to price in policy expectations of "higher rates for longer."

According to Bloomberg, Leuthold's statistics on data since 2003 found that when the Citi Economic Surprise Index breaks above the strong zone of 40, the S&P 500 is highly likely to record negative returns over the following three weeks, on average needing about three months to recover losses. With US stock valuations still high and the market becoming more sensitive to Fed policy, the impact of economic data is undergoing subtle changes.

Historical data shows: "The stronger the economy, the more easily the stock market corrects"

Leuthold reviewed the historical performance of the Citi Economic Surprise Index and the S&P 500.

Research shows that since Citi introduced this index in 2003, there have been 28 instances where the Economic Surprise Index exceeded 40, and the S&P 500 subsequently registered negative returns over the next 21 trading days, on average requiring about three months to make up for declines. Currently, the Citi Economic Surprise Index stands at 50.3, still clearly above the critical level of 40, meaning the US economy overall continues to surpass market expectations.

Leuthold's Multi-Asset Strategy Head Chun Wang noted that in the past two to three months, the "good news is bad news" logic has been particularly apparent. However, he also pointed out that the biggest difference in this cycle compared to history comes from disturbances caused by the Middle East situation. The US-Iran conflict has pushed up oil prices and breakeven inflation rates, adding extra noise to the market and making investors more sensitive to inflation and policy paths.

Fed expectations have become the core market variable

Continual economic outperformance means the Fed's difficulty in achieving its 2% inflation target may rise further, prompting the market to readjust its judgments about the future interest rate path.

Explosive Options founder and chief strategist Bob Lang said: "Monetary policy may see new changes next week or this fall, reflecting a potentially more hawkish stance by policymakers to fight inflation."

Sameer Samana, global equities and real asset head at Wells Fargo Investment Institute, believes the recent weak performance of the S&P 500 is not entirely driven by economic data; internal rotation within technology and AI stocks has also played a key role.

However, he also stated that some investors indeed see persistent strong economic data as a reason for the Fed to maintain high rates or even tighten policy further.

High valuations amplify the "good news turns bad" effect

Changes in the market environment are closely related to valuation levels. Since the end of March, the S&P 500 index has risen about 17%, meaning a lot of optimistic expectations are already reflected in stock prices. Against this backdrop, new economic positives are unlikely to push valuations further, but can easily trigger concerns about policy tightening among investors.

Ken Mahoney, CEO of Mahoney Asset Management, said: "The most ideal economic scenario may have been fully priced in by the market—robust economic data has now become a source of pressure for stocks, and the way the market interprets news has changed asymmetrically."

For the outlook, Chun Wang recommends that investors maintain relatively balanced risk allocations. He said that the current market "is not bad enough to warrant extreme pessimism," but with geopolitics, inflation expectations, and monetary policy intertwined, today's market is more complex than historical experience.

He summarized: "Today, the stock market has become a part of the economy itself. The biggest economic risk comes from the potential reversal of the wealth effects of the stock market. Thus, it remains more appropriate to maintain a neutral stance in asset allocation and risk exposure."

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