October’s CPI fell short of expectations and sparked an explosive rally on Wall Street, with the S&P 500 (SPY) rising more than 4% and bonds rocketing as well. Essentially, the chances of a soft landing increase if inflation can get lower and then stay lower. This development would also likely cause the Fed to slow the pace of rate hikes. Of course, the next big question, assuming inflation has peaked, is how low will it fall? Will it plateau at higher levels or will it fall back to the 2% range? Today’s commentary will explore these questions and the implications for our portfolio. Read on below for more information….
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(Enjoy this updated version of my weekly commentary originally published Nov. 11)e2022 in the Newsletter on POWR Shares Under $10).
For the past week, the S&P 500 (SPY) rose by 6.4%. After the FOMC, stocks were quite choppy before roaring higher following the softer-than-expected CPI report.
It should be obvious to everyone why falling inflation is a big problem, as it would essentially mean that a huge headwind in the market turns into a tailwind.
Falling inflation would in itself bring relief to consumers and lead to increased margins for companies.
In addition, it would lead to lower rates, which would also stimulate the housing market and reduce borrowing costs for corporations.
Essentially, it would undo much of the market pain. And that was evident in today’s action, which saw the leadership of both homebuilding stocks and speculative technology stocks as both groups were plagued by rising interest rates.
So it makes sense that if prices are going to reverse and move lower, these are the groups that will outperform at the top.
Path of inflation + profit
In retrospect, it appears that inflation peaked this summer. And it’s possible that the stock market successfully sniffed this when it bottomed out, along with the high value in the CPI.
Then these lows were retested and undercut in October with a lower high for the CPI but a higher high for the core CPI, before recovering higher again in recent weeks.
Going to the CPI report, I had mixed views on the number, but leaned bearish on the market due to an aggressive Fed and a slowing economy.
The inflation value neutralizes the first factor, at least for the short term. This is evident in the large decline in yields, and higher inflation would be needed to reach new highs in yields.
In fact, I am convinced that we have seen the cycle with high yields.
This means that the bearish case is based on seeing a contraction in earnings, pushing stock prices lower again.
And in the longer term, the path inflation takes will determine the Fed’s policy and whether we are in the end or mid-stage of the bear market.
Portfolio implications
Prior to the FOMC, we moved to a neutral stance. And ironically, by the end of today, we’ll be back at that level.
Even with above-average cash allocation, our portfolio grew by more than 3% and we had numerous stocks that were up between 5 and 9%. YTD, the portfolio is down 5% as the broader stock market (SPY) is down 15% with an even deeper drop for the Russell 2000.
As I mentioned above, I think the CPI report is a game changer… in the short term. It should place a bid below the market as it removes bearish risk – yields continue to rise as inflation ramps up.
In the more medium term, if we assume inflation continues to fall, the focus will shift to earnings.
If earnings can remain stable or even continue to grow, then I think equities will continue to rise. If earnings start to take damage, stock prices could fall along with yields and inflation.
As for the portfolio, I’ve been avoiding a lot of technology and housing stocks because of the relentless rise in yields. This is no longer the case and I think we can go bargain hunting among this group.
Overview
The FOMC meeting was bearish, as it meant the window for a “soft landing” had been narrowed.
In my view, the latest CPI strengthens the bullish case and could strengthen the bullish case significantly if it turns out to be the start of a trend of declining inflation.
But it’s too early to say if this is the case. And we also have the dynamism of a slowing economy that is enough to pull stocks down even if inflation gets lower.
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All the best!
Jaimini Desai
Chief Growth Strategist, StockNews
Editor, POWR Shares Under $10 Newsletter
SPY shares closed at $398.51 on Friday, up $3.82 (+0.97%). Year-to-date, the SPY is down -15.12%, versus a % increase in the benchmark S&P 500 index over the same period.
About the author: Jaimini Desai
Jaimini Desai has been a financial writer and reporter for nearly a decade. His goal is to help readers identify risks and opportunities in the markets. He is the Chief Growth Strategist for StockNews.com and the editor of the POWR growth and POWR Shares Below $10 newsletters. Learn more about Jaimini’s background, along with links to his most recent articles.
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