The October CPI came in below expectations and fueled an explosive rally on Wall Street with the S&P 500 (SPY) up by more than 4% and bonds also shooting higher. In essence, the odds of a soft landing increase if inflation can turn lower and then keep moving lower. This development would also likely cause the Fed to slow its pace of hikes. Of course, the next big question, assuming that 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 to find out more….
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(Please enjoy this updated version of my weekly commentary originally published November 11th, 2022 in the POWR Stocks Under $10 newsletter).
Over the last week, the S&P 500 (SPY) is up by 6.4%. Following the FOMC, stocks were pretty choppy before roaring higher following the softer than expected CPI report.
It should be obvious to anyone why falling inflation is a big deal as it basically would mean that a massive market headwind turns into a tailwind.
Falling inflation, on its own, would bring relief to consumers and lead to margin expansion for companies.
In addition, it would result in rates turning lower which would also boost the housing market and reduce borrowing costs for corporations.
In essence, it would reverse a lot of the market pain. And that was evident in today’s action which saw leadership from both homebuilding stocks and speculative tech stocks as both groups have been hammered by rising rates.
Thus, it makes sense that if rates are going to reverse and turn lower, these are the groups that will outperform on the upside.
Inflation’s Path + Earnings
In hindsight, it’s looking like inflation peaked this summer. And, it’s possible that the stock market successfully sniffed this out as it bottomed along with the high reading in the CPI.
Then, these lows were re-tested and undercut in October with a lower high for the CPI but a higher high for core CPI, before once again recovering higher the last couple of weeks.
Going into the CPI report, I was of mixed opinion about the number but leaning bearish on the market due to a hawkish Fed and slowing economy.
The inflation reading neuters the former factor at least for the short-term. This is evident with the big decline in yields, and it would take higher highs in inflation to get new highs in yields.
In fact, I’m confident that we have seen the cycle high in yields.
This means the bearish case rests on seeing a contraction in earnings which causes another leg lower in stock prices.
And on a longer-term basis, the path that inflation takes will determine Fed policy and whether we are in the end stages or middle stages of the bear market.
Portfolio Implications
We moved to a neutral stance prior to the FOMC. And ironically we are back to those levels at today’s close.
Even with a higher than average cash allocation, our portfolio was up more than 3%, and we had numerous stocks that were up between 5 and 9%. YTD, the portfolio is down 5%, while the broader stock market (SPY) is down by 15% with an even deeper drawdown for the Russell 2000.
Like I said above, I do think the CPI report is a gamechanger… in the short term. It should put a bid under the market as it removes a bearish risk – yields constantly marching higher as inflation spiraled upwards.
In the more intermediate-term, if we assume that inflation keeps falling, then the focus will shift to earnings.
If earnings can stay flat or even keep growing, then I think stocks will keep rallying. If earnings begin to show damage, then we could see stock prices fall along with yields and inflation.
In terms of the portfolio, I have eschewed many tech and housing stocks due to the relentless rise in yields. This is no longer the case, and I think we can start bargain-hunting among this group.
Summary
The FOMC meeting was bearish, because it meant that the window for a ‘soft landing’ had narrowed.
In my opinion, the latest CPI does strengthen the bullish case and could significantly bolster the bullish case if it proves to be the start of a trend of falling inflation.
But, it’s too soon to say if this is the case. And, we also have the dynamic of a slowing economy which is enough to pull stocks lower even with inflation moving lower.
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All the Best!
Jaimini Desai
Chief Growth Strategist, StockNews
Editor, POWR Stocks Under $10 Newsletter
SPY shares closed at $398.51 on Friday, up $3.82 (+0.97%). Year-to-date, SPY has declined -15.12%, versus a % rise in the benchmark S&P 500 index during 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 Stocks Under $10 newsletters. Learn more about Jaimini’s background, along with links to his most recent articles.
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