Well, that was weird.
Tuesday’s Consumer Price Index data showed inflation slowed for a second straight month. Then, the Fed announced a smaller rate hike than in previous months, showing some light at the end of the tunnel after an aggressive year.
People got the welcome news they were looking for, yet the stock market went nowhere.
Wall Street has been all about the data lately. Inflation this, job openings that. The obsession with data has led to some of the biggest swings in prices we’ve seen around major data releases in years.
Of course, the data still matters. But this week, it became apparent that the market is starting to see data through a different — foggier — lens.
A change of heart
The trends are clear. Inflation is slowing down dramatically, which shows the Fed’s medicine is working and the world is getting back to normal. The Fed is taking notice, too — Fed chair Jay Powell admitted as much in his comments this week.
But what encouraged investors just weeks ago (a lower CPI print, a Fed shift) actually sparked a selloff. The market’s mood can be fickle, but this felt like an especially brisk — and painful — change of heart.
Here’s what likely changed everyone’s minds:
Good, but not good enough. Inflation is moving in the right direction, but that may no longer be enough. Why not? Because normal could still be far away. In the 2010s, the average pace of inflation was around 2%. We might not return to that for a while. In the Fed’s eyes, it could take until 2024.
The other details aren’t good enough, either. A 50-basis point hike isn’t exactly small, and Fed officials expect to keep their policy rate north of 5%, around where it was before the Global Financial Crisis. This week, the Fed also lowered its forecast for growth and raised its expectation for unemployment next year. We’re one step closer to conquering inflation, but we may also be one step closer to triggering a recession.
It’s not a pivot. We’ve said this a lot recently, but this shift isn’t a pivot. In other words, if you’re expecting rate cuts any time soon, I wouldn’t hold your breath. And if rate cuts do come soon, it’s probably because something in the economy is breaking. That wouldn’t be good.
If we avoid a recession, rates could stay relatively high for a while, and high rates could force investors to think twice about taking on excessive risk.
The bar is high. Stock prices have shot up since mid-October, and we’re just now running into resistance. There are a lot of theories as to why, but I think it’s simply a matter of high expectations.
To understand why, look at how much stocks are actually worth at these levels. The S&P 500 has climbed about 10% since mid-October, but earnings estimates for the next 12 months have actually dropped over that period. The earnings yield — or the amount of profit generated per share of a company — is sitting around 5.5%, just a bit higher than short-term Treasury yields (and noticeably lower than 7% inflation).
Stocks tend to move on a mixture of present data and future beliefs, and we’ve leaned into the future beliefs part of the equation in this latest rally. There’s nothing wrong with feeling hopeful, and investors probably did get too pessimistic this summer. But our hope has made stocks look expensive, relative to bonds and cash. And when stocks are expensive, investors may have a lower tolerance for less-than-perfect data.
The data lens changes constantly. Even if you think the narrative is obvious, the interpretation of news can drive prices more than the news itself. This is true no matter what the economy is doing or what the Fed is saying. Over time, stocks tend to follow the economy and earnings, but more often than not, the day-by-day moves are anybody’s guess.
Following the headlines
Now more than ever, it’s important to understand what the totality of data is telling us, relative to where markets are trading. Try not to base your portfolio decisions on one piece of data, and stay nimble so you’re not caught off-guard. Plus, since we’re not out of the woods yet, think about hedging your portfolio if you plan on piling back into risk.
It’s also important to know what your portfolio goals are. Focus on what suits your investing and time horizon the best, instead of what headlines you think will move the market.
And since we’re in the holiday season, don’t get too caught up in the news. We all deserve a break.
Thanks for reading The Bottom Line this year! We’re taking a holiday break for the rest of 2022, and we’ll be back in 2023.
Happy holidays!
*Data sourced through Bloomberg. Can be made available upon request.