The rally seen in equity markets post-CPI has been largely met with skepticism. This is essentially true of the gains seen over the past week and past month. Below is a comment from a sellside strategist and is emblematic of the pushback we get from clients (keep in mind, the sellside often mirrors what institutional investors broadly are saying).
As to why, we think much of this is explained by an anchored cognitive bias. The following contributes to investors seeing “half-empty”
- Fed is raising rates and the binary conclusion is stocks go down
- Inflation has been problematic for the past 16 months, and investors see it as “sticky” ala 1970s-80s, meaning it will linger for years and years
- Stocks have been falling, so the momentum is negative
- Stocks are rising only for “technical reasons”
On that latter point, I had lunch this week with an institutional investor who in summary said:
- “there is no fundamental reason for stocks to be going up, especially if someone cares about earnings”
- “the only people who are bullish are doing it for technical reasons, has anyone ever met a really rich technician?”
- “name one fundamental investor who likes stocks here, there are none”
- you get the picture. Deep skepticism.
But as we have discussed multiple times in our commentaries, we believe stocks are rising for the right reasons. There are multiple factors (see section below) but we view August 1982 as the best analog. When inflation apexes, markets see this first and then the Fed reacts.
Breadth of rally is expanding…
Notably, the breadth of this rally is expanding. There are multiple measures but Mark Newton, Head of Technical Strategy, notes two measures that are useful:
- the advance/decline line is breaking to the upside (see below)
- small-caps relative performance is breaking out to the upside
These are both solid measures of market breadth and show the rally in stocks is broadening. This lends further credence to the rally.
Rally breadth is expanding = risk/reward favors a focus on “lower quality” and “small-caps”
And in the past, when breadth is expanding, risk/reward improves for both “lower quality” and “small-caps” with the rationale being:
- improving financial conditions favor companies with lower margins = lower quality
- interest rates flattening favors companies with higher debt leverage = lower quality
- improving Fed outlook and lower inflation favor smaller players = small-caps
BREADTH STOCKS: 6 stocks that leverage the expanding market breadth
Our data science team, led by tireless Ken, has put together a list of stocks that have improved risk/reward. These stocks meet the following criteria:
- lower quality on margins
- higher leverage levels
- attractive on FSInsight’s Quant Model quintile 1
- attractive technical characteristics as determined by Mark Newton
There are 6 names. The list and tickers are below:
COGNITIVE BIAS:Humans have a cognitive bias that impacts perception of incoming data
We have posted this below example previously. Notice how our brains see these balls as colored? Yet, in fact, these balls are all the same color. I know this is not exactly the same as how investors view markets, but the same process is at work.
- every incoming data point is compared to a working baseline view
- and human cognitive bias can often overfit how this data is interpreted
Inflation seems to be inflecting in the “hard” data but many argue nothing has changed
At FSInsight, we suffer the same risk, but we try to course correct. And our collaborative process of incorporating demographics, historical context, technicals, fundamentals, quantitative and investor surveys provides us balance:
- today, we think the views on inflation are overly pessimistic
- inflation is difficult to predict and forecast
- but the July CPI (8/10) and July PPI (released 8/11) are showing a pronounced break in pattern
- this break is a sharp slowing
- and corroborates the visible and consistent easing of inflationary pressures seen in commodities, durable goods, inventory corrections, alternative data and even consumer surveys
July PPI is a “break” in pattern— DEFLATION
The July PPI came in below expectations with producer prices DEFLATING in July:
- PPI down -0.5% versus consensus +0.2%
- June PPI +1.1%
- deflation, yup
And as shown below, this is a break in pattern:
- PPI has not been negative MoM since May 2020
- hard to ignore, right?
July CPI is a “break” in pattern — “hard” data starting to reflect disinflation seen in leading indicators
The July CPI report seems to be changing the minds of the “inflationists” who have argued inflation would be sticky for years, and as a consequence, the Fed would need to “burn the economy to the ground.”
- instead, July CPI actually DEFLATED by -1.93bp month-over-month
- yup, deflation
- the July headline CPI is the lowest reading since June 2020
- inflation eased far faster than consensus argued
- bonus: July CPI came in -20bp below consensus estimates
The deflationary impacts of some categories show that inflationary pressures are not uniformly accelerating:
- Energy was the biggest contributor -0.42pp of the headline decline
- Travel was a -0.09pp
- Used cars and rentals was -0.02pp
- 3 categories that contributed to massive surges in inflation throughout 2022 turned into deflation contributors
And as we noted earlier this week, gasoline is tracking for a decline in August. And the CPI impact will amplify:
- July gasoline subtracted -0.41pp
- August gasoline to subtract -0.81pp, or 2.0X the impact
- deflationary pressures larger in August
Figure: FSInsight Portfolio Strategy Summary – Relative to S&P 500
** Performance is calculated since strategy introduction, 1/10/2019
