Another Tough Week on Wall Street

Another tough week for everybody on Wall Street. Dow off 4.1, S&P off almost 5%. Nasdaq down 5.5. The International Index, the IFI, off 1.8. Ten-year treasury, 1.9% positive for the year. And oil, what a pullback, right? Oil traded at $85 this week. Oil is only up 13% year to date. It was up almost 40% not too long ago. Bonds are off 12% year to date.

What should you do? First of all, Tuesday was a big wake-up call. It was a tough week. A very, very hot Consumer Price Index (CPI) report came out. For the second time in less than three weeks, the market didn’t like it. I call this a binary event. The market rallied up over the last three weeks, but Tuesday put out some bad information. And all of a sudden, boom. The market reaction on Tuesday was similar to what we saw Friday. Remember after Chairman Powell said that he was going to keep raising rates more than everybody thought, and the market didn’t like that. The S&P 500 gives back the majority of the recent bounce that came over the past few weeks.

Hot CPI Report

Inflation is just not going away, and with this hot CPI report Tuesday, I got questions this week like, is that a bearish game-changer? Are things going to get a lot worse, Mr. Sandman? The answer is I don’t think so—and here’s why. First, it didn’t materially alter the rate hike expectation overall. This week, the big event’s going to be Wednesday as the Fed announces what they’re going to do. I’m expecting a 100 basis point rise, or a 1% raise. Additionally, the market is now pricing in a greater chance of a 75 basis point hike in November. Before, it was 50. But most importantly, that hot CPI number on Tuesday didn’t alter the outlook for what we call the terminal rate from the Fed. And prior to the report, the terminal rate was right around 4.125. After the Tuesday event, the futures are now showing that rate to be 4.25 to 4.50. So again, that’s about a 25 basis point hike, a quarter of 1%. Don’t lose your breakfast because of that.

Has Inflation Peaked?

Second, while it shows inflation is sticky, it didn’t invalidate the idea that inflation has peaked. Let’s look at inflation, shall we? The three inflation reports this past week that I looked at all had the same conclusion: Core inflation is resilient. It’s more resilient than the market had thought, and we saw this in all the reports. The core reading, excluding food and energy, was hotter than expected. And the reason that markets are seeing this is that inflation is distributed throughout the economy. If you go out to dinner, flying on an airplane, renting a hotel room, paying for your insurance, renting an apartment, paying for medical treatment, what are you noticing? It all costs more money than a year ago. So, the hope this summer that as the oil prices started to decline, all our prices would drop too, well, that’s just not really happening. This inflation phenomenon right now isn’t commodity driven. I’m going to say that inflation was a problem before the Russia-Ukraine war, which caused oil to rise.

Inflation is a problem, and now that those commodities have returned to normal levels, I think the main reason for inflation right now is this: There’s too much money still in the system chasing too few goods. What am I talking about? Look at the money supply, called the M2. It was 15.5 trillion in January ’21. It’s just under 22 trillion now. So, that’s obviously higher. There’s almost 50% more money right now in circulation than there was about two years ago. Also right now, there are twice as many job openings—about 11.5 million—as there are people actually looking for jobs. The unemployment rate, 3.6%, that’s full employment. The S&P 500 was just under 3400 points in early 2021. Now, it’s up to 20% more in just about two years. So again, the market’s elevated. And in January 2020, the average price of a home seen through the Case-Shiller index was 214. Guess what it is now? 306. That’s nearly a 50% appreciation in home prices. My point is rates have risen sharply, and the economy has lost momentum, but we still have a lot of liquidity in cash in the marketplace.

And the supply chain remains challenged. There’s something called the Drewry World Container Index that monitors the dollar cost for a 40-foot container: $10,000 in 2021. It’s 5400 now. But what was it pre-pandemic? 1800 dollars. The point is things have improved, but they’re still not back to normal. For inflation to really change, I need to see reduced demand, meaning slow down, people spending, and/or an improved supply. Until we see China fully reopen, that’s going to be a problem.

What’s the Outlook From Here?

So, what do you do now? Where should you go now? Well, in the near term, bonds are pretty attractive right now. I’m seeing some really good rates this week. As those rates continue to get more attractive, you can get almost 4% now from a treasury. Technology stocks are going to get hit. Anything that borrows money is going to get hit, so you’re going to want to move out of those if you haven’t already. Until we see this pattern of lower inflation established, equity is going to be in trouble. Longer term, for those of you holding on to your things longer, don’t panic. There could be some more downside. As I said, 3900 was the support level on the S&P 500. We got through that this week. We’ve got down below that. So, the next stop’s 3600. The next stop below that is 3400.

The bulk of adjustments, though, in the valuations of stocks, meaning this movement, I think is behind us. And if you look at the last 26 years, the price-to-earnings ratio has contracted 24% on average during sizable market downturns and/or bear markets, which we’re in right now. Right now, we’re off about 26% in the S&P 500. I think this adequately compares to history. Stocks look forward, and historically, they tend to bottom before the data starts to improve. The average bear market since World War II has lasted about 11 months. You’re nine months in right now. This year’s painful drawdown in both bonds and stocks has improved longer term. But the starting point in both bond yields and equity values are now very different than they were in December. So, the bottom line is with the Fed firmly on the brakes, they’re pressing those brakes, they’re trying to slow down, and the macroeconomic backdrop is challenging. You have to be patient. We talk about this all the time when you drive a car. Be patient. Don’t get on that gas too early. Markets might stay within this range for a while, but eventually, they’re going to recover andostart to move upwards, but you have to be patient and make sure you’re positioned properly.

Next week, the big news is going to be the Fed. They’re going to announce on Wednesday what they’re going to do. I’m expecting the 1% raise. Anything less than that, I would expect a little bit of a rally.

Data Source: FactSet

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