“To hell with circumstances – I create opportunities.” ~ Bruce Lee

Good evening,

Before the markets opened on Nov. 1, Tom Lee, Fundstrat’s Head of Research, alerted investors to a burgeoning “baby rally.” Lee made this call after observing the bearish positioning of both institutional and retail investors, as well as the low levels of leverage in the markets. As this week began, those conditions continued to hold – despite Lee’s call for CPI data to show inflation continuing to glide lower.

That led on Tuesday to a “face ripper” rally, as lower gasoline prices led headline CPI down and Core CPI came in at 0.23% MoM versus Street expectations of 0.30%. While this was consistent with his expectations, Lee also noted that “the softside reading came in the right places” – shelter (comprising 42% of Core CPI) and cars (the second-largest component after housing). 

In the view of Ken Xuan, Head of Data Science, home prices are critical to the current fight against inflation. “That’s a key battlefield,” he said at our weekly research huddle. “And we know that the home prices are about to fall because of the lagging effects of how the BLS collects home-price data,” he reminded us.

Lee was also tracking used car prices. “Many  investors underestimate how much used cars actually matter to CPI,” he told us, pointing out that this figure alone accounts for 5% of Core CPI. Today, the latest numbers from the Manheim Used Car index, which leads the analogous CPI component by two months, showed used-car prices deflating at 19% annualized. 

Housing and cars are both shown in our Chart of the Week:

Although CPI was arguably the most important macro data released this week, it was not the only significant data point being reported. Xuan noted that, “We saw multiple sources showing  inflation continuing to head down – not just the CPI report, but also Wednesday’s retail sales report and also the PPI report.” Headline PPI declined by its largest share since April 2020, -0.5% MoM versus Street expectations for an increase of 0.1%. Core PPI also came in significantly soft, unchanged versus consensus expectations of +0.3%.

Xuan said, “I thought the retail was especially interesting, because it shows that even though pricing pressure and inflation are actually coming down, the economy is still resilient, with sales higher than expected. We are also hearing that from retailers like Walmart,” he pointed out.

On the company’s earnings call this week, Walmart CEO Doug McMillon said, “In the U.S., we may be managing through a period of deflation in the months to come.” And on Home Depot’s earnings call, the company’s CFO Richad McPhail similarly told analysts that, “I think the most important observation we’ve made is that the worst of the inflationary environment is behind us.”

The US 10-year yield plummeted in response to the week’s data, hitting 4.45% on Tuesday and ultimately ending the week at 4.44%. Mark Newton, Fundstrat Head of Technical Strategy, noted that “the big equity breakout happened exactly as Treasury yields also rolled over, so that correlation is very much still in place and something to watch carefully.”

Still, he continued to urge caution. “I am still of the opinion that this could be a five-wave decline, which, for those who aren’t fluent in Elliott Wave [Theory], means that it might be difficult for the market to immediately just move up, get above 4600 and go off to the races,” he said. 

“When we look at our larger chart of the 10-year, it makes me a little wary because I do sense that the 10-year treasury yields are down near support. Rates broke out around [4.37%]. We're now at 4.44%. It wouldn't take much for this to get back down here and I think it will, sometime next week. This should be very important support for yields. I'm expecting that we can bounce in yields between now and mid mid December. So if that happens and if the correlation between yields and equities remains, that means equities also likely pull back a bit and we don't immediately scream to the highs.”

On the other hand, Newton suggested, “if [yields] break 4.30% and we really started to accelerate, that would be a welcome change for equities. But right now, I'm not expecting that.”

“I am expecting that markets to rally in the next week, but we are approaching levels that should be very important in terms of resistance and could be followed by weakness between late November and mid December.” Longer-term, Newton remains constructive, pointing out that Fed futures trading implies that the market “has largely stripped out the possibility of any further Fed hikes” for this cycle. “As of now they're [also] pricing in substantial cuts in 2024, 50 basis points alone for July.”

For Lee, the week’s macroeconomic and market events further strengthened the fundamental case for an equity rally into the end of 2023. “As inflationary pressures ease, this should lead to lower interest rates, a weaker dollar and dovish changes in Fed futures,” he said. Fed futures trading implies that the market already expects that the Fed is done with rate hikes for this cycle, with investors increasingly pricing in odds that the Fed will begin cutting rates in May 2024.

Newton on Energy:

“Crude oil is actually breaking early November lows, and this is setting us up for a further deterioration in energy over the next two weeks. We are however getting near a possible bottom in crude which I think is going to happen right at the OPEC meeting November the 26th, a very important date. It lines up with cycles. 

“They're blaming the current decline on speculators but I believe it’s more due to a perception of lack of demand. In addition, seasonally we are in a very difficult time for Energy. October and November are the worst months of the year.”