Markets Shrug Off Disappointment After Red Wave Fails to Materialize, Climb on Decelerated Inflation Numbers
Our Views
The October CPI was a “game changer” supporting equity rally into YE.
The October core CPI (released 11/10) came in at a soft +0.27%, below Street consensus of +0.5% and break in trend from the +0.6% seen in August and Sept CPI. As we noted earlier this week, our view is the market would view soft Oct CPI as a “game changer” and arguably in far greater magnitude than the massive bearish reaction to Aug CPI (stocks down 15%).
- The S&P 500 rose +5.5%, an eye-popping rally, and so the soft CPI had a seismic impact
- Many inflationistas skeptically suggested this soft reading is not repeatable
Source: Bloomberg
But 3 drivers were behind this soft CPI, which we view as “repeatable”:
- Shelter finally showed a meaningful slowing in CPI MoM, as OER (owners equivalent rent, >23% of CPI basket) slowed to +0.6% (+0.7%/+0.8% Aug/Sept) and trending towards market reality of deflation in housing
- Durable goods finally showing “bullwhip” payback as durables CPI fell to -0.7% MoM (-8.4% annualized) and even used cars finally showed some weakness down-2.4% for the month (but still 15% further to fall)
- Medical health insurance massively flipped to -4% MoM from 12 consecutive months of +2.4% (since Oct 2021) and given annual adjustment is set to fall 40% over the next 12M
- In other words, there are building drivers to massively slow CPI core inflation over the few months and it is possible we will see 3 to 4 consecutive months of +0.3% Core CPI MoM
- This would pull down core inflation towards 3.5% or so. Far slower than the 6.5% seen in most of 2022
As far as market implications, we think the case for a strong rally into YE has been strengthened:
- Foremost, Fed no longer has its “back to the wall” on inflation as October CPI beat looks repeatable (see above) and therefore the case for a pause after December is stronger. This counters the hawkish rhetoric of Powell post-FOMC but he did not have October CPI in hand.
- For most of 2022, Fed has not been able to point to measurable progress on containing inflation but a significant constellation of leading indicators showed deflation/soft inflation was in the pipeline. October CPI is the first month the “hard” data syncs with the “soft” data.
- Softening inflationary pressures strengthen the case for a “soft landing,” counter to the consensus narrative that Fed is spiraling economy to a hard landing. Core inflation running at 3.5% annualized (above) will not require Fed to bang out +75bp and arguably 4.5% Fed funds would be very tight.
- A Fed shifting from “higher in a hurry” to “predictable but possibly longer” is far better for risk assets. Fed has acknowledged serious and unknown lags in monetary policy and with inflation improving, Fed can gain some measure of patience.
- While some bears say the Fed doesn’t want equities to go up, this is an oversimplification. Fed just was in a hurry to slow things down in 2022. Stocks are far more complex than bonds which are arguably two variable assets (inflation and future Fed funds).
- Stocks are acting like “beach balls under water” because P/E averages 19X when 10Y between 3.5% to 5.5% — true since 1871. Thus, those arguing P/E should be 15X or less are just plain ignoring history.
- The “false dawn June pivot” rally lasted 23 trading days and saw S&P 500 rise +16%
- We believe this “Fed pause” rally should last closer to 50 days and push S&P 500 +25% higher. Thus, we think S&P 500 should surpass the 200D average of 4,100 and given possibility of another weak Dec CPI could see a move well beyond that. Why wouldn’t 4,400-4,500-plus be a possibility?
- Recall, in 1982, following the final low in August 1982, the S&P 500 reached a new all-time high within 4 months, erasing entire 27-month bear market. That was a vertical rally. Vertical.
CPI: Good month even for food…
Our data science team’s, led by tireless Ken, found that the top 10 drivers of inflation remain the same but with diminishing magnitude:
- Shelter largest contributor but the CTG was 20bp down from 25bp
- New Cars is #9 at 1bp but down from 3bp
- 17 items outright DEFLATED MoM and that is accelerating slowing of CPI MoM
Our dashboard of 35 items show that more than 50% of factors are in outright deflation.
REGIONAL CORE CPI: All 9 regions see slowing Core MoM
The trend of Core CPI MoM for each of the 9 regions is shown below. And we can see the clear deceleration of inflation MoM.
1982: Valuation nor earnings constrain stocks, if inflation has bottomed.
We don’t know if the Fed has vanquished inflation. But we have written in the past that Powell doesn’t have to go full “Volck-an” as the cumulative inflationary pressures as far lower in 2022 than 1980s. As shown below, the cumulative inflation in 2022 is about 7% above trend compared to +72% when Volcker became Fed chair. That is far less inflation that needs to be erased from the mindset of households and businesses.
And the stock market “sniffed” out the end of inflation war 10 weeks before Volcker even posited a change in inflation tactics. His first public musings were not until October 5, 1982.
- by then, equities were furiously rallying as shown below
- and made new all-time highs only 4 months after the bottom
- a vertical rally
- The DJIA had already broken out above its downtrend from early 2022, but the QQQ has just started its bounce and successfully broke out above late October peaks as the week came to a close. Markets are heading into a historically tough time of the month of recent history is any guide, as the last three peaks all happened between the 13th and 15th of the month. Yet, breadth has expanded sharply and should allow for some cushion on any pullback to consolidate gains ahead of the US Thanksgiving holiday.
- Don’t look now, but the DJIA’s rally has brought it to within 7% of its all-time high close as this week has come to a close. In what was thought to be a nearly impossible feat, DJIA has successfully broken its downtrend for 2022, led by strong performance out of stocks like JPM, CAT, GS, BA, IBM and INTC.
- SPX issues above 200-day moving average are now above 50%. We’ve seen intermediate-term breadth gauges show some real strengthening despite many benchmark indices still well under ongoing downtrends. It’s largely been the Tech-heavy NASDAQ that has underperformed, and the downtrends in both SPX and QQQ look deceiving given the broad-based strength we’ve been witnessing in other sectors.
- Rally off the October low continues based on dovish hopes following the CPI data release this past week. Despite the violent surge higher in equities and large movements in other classes, my research has not budged at all over the last five months. In fact, my key indicators have become even more unfavorable. Based on my key indicators, Thursday’s report does not change that much. Yes, CPI was soft and will likely lead Chair Powell and Gang to downshift and only raise the funds rate 50bps at the upcoming December FOMC meeting. From my view, it is important to be mindful of the Fed’s words that state they need to see a consistent trend in falling inflation to even start considering a shift in the Fed’s ongoing mission to fight inflation and increase labor market slack. My work suggests that coming data releases will not clearly support a dovish pivot as soon as the bulls are counting on.
- Deep dive analysis into my 4000+ U.S. single-stock universe this past week confirmed my longstanding view that forward earnings still look too high. When looking at the level of operating earnings forecasted as shown by the bottom-up consensus of the analyst community, the 2023 outlook for the S&P 500 is roughly $235. When looking through both the company-level data and my preferred top-down analysis, I keep coming up with a range of only $210-215, which would confirm that 2023 OEPS cuts are likely still coming.
- P/E multiples still look too high based on my work, and the current environment does not support readings of 18x or greater. Hence, it appears more downward adjusting needs to be done before equities are compelling on a valuation basis.
- Consequently, I am still advising that bounces should be viewed as bear market rallies that will likely fail and should be used to sell into, reposition, raise hedges, and to reload shorts. Any tactical gains or outperformance for now is just the side show while the MAIN EVENT of pivoting for THE bottom that is still in front of us.
- Since about March, we haven’t had a three-month period where equity markets have contributed positive return. This is likely to continue even with Thursday’s bounce. The equities markets are heavily overvalued.
- For the equity market to be more fairly valued, earnings need to rise. But that is unlikely. Top-line revenues are going to decelerate because they are strongly correlated with inflation, which has peaked and is starting to roll over. Margins are also heading down, based on margin sentiment, a leading indicator.
- So I am still a negative on the market intermediate term (six to nine months).
- Investors were positioned negatively going into earnings season anticipating really bad news. So companies who beat earnings were rewarded very heavily, boosting the market. With earnings season about to end, that tailwind is going to evaporate.
- Sam Bankman Fried (SBF) allegedly stole an estimated $4 billion of customer deposits for Alameda, the fund in which he has a large ownership stake. Alameda subsequently lost these funds, and now due to declining prices and a run on FTX, the liquidity shortfall has expanded to an estimated $10-50 billion.
- On Wednesday, things came to a head when Binance walked away from a deal to purchase FTX. Crypto markets made new YTD lows on the news as investors scrambled for liquidity in anticipation of additional forced selling.
- On Thursday, we had an enormous downside surprise on CPI, sending rates forcefully lower. Stocks had their best day since 2020. Naturally, this risk-on-price action was conducive to oversold cryptoassets.
- On Friday, FTX filed for Chapter 11 bankruptcy protection, which seems to include the US entity, furthering the risk of contagion.
- We think it is appropriate to wait for lower lows as there is good reason to think that there will be other casualties, which could lead to forced selling or, at the very least, bad headline risk.
- Key races remain undecided. However, at this point it appears that control of the Senate will have to wait for the December 6 run-off in Georgia, and when all the tight races are decided Republicans will hold a narrow five to ten seat majority in the House.
- Assuming Republicans take control of the House their narrow majority will make legislating a challenge for leadership. On several occasions, Speaker Pelosi and her team had to craft legislation to achieve a balance between the most left-leaning progressive members of the Democratic caucus and those more moderate members from swing districts. McCarthy and his team will have a similar challenge as pro-Trump members that include Marjorie Taylor Green, Matt Gaetz, and others are likely to do the former President’s bidding on issues ranging from the debt ceiling to immigration.
- Congress needs to return after Thanksgiving to finish its work. When the House and Senate left for the elections they punted the government funding deadline until December 16 and they will need to act in order to avoid the threat of a government shutdown days before Christmas. Prior to the budget deadline, control of the next Congress should be determined. and this will likely influence decisions in the closing days of the current Congressional session. A big decision for the Republican leadership will be whether the new spending bill should run for the entire fiscal year until October 1, 2023 and let Rs write the budget for the new year or have another short-term CR that runs until February or March when Republicans will control the House.
- Related to the spending bill is the national debt ceiling. Raising the ceiling is obviously a must pass bill, but it comes with lots of political risk. The current debt ceiling is $31.4T, but at some point in 2023 the ceiling will need to be raised and with a divided government the fight will be messy and create headline risk for markets.
- Republicans will undoubtedly try to reverse some of the tax policies passed by the Democrats in the Inflation Reduction Act and enact new ones that create incentives for investors and energy. Republicans will have leverage when the budget and debt ceiling are considered, but it is unlikely that Congressional Democrats or President Biden will give much away on tax policy.
Wall Street Debrief — Weekly Roundup
Key Takeaways
- U.S. equity markets began this week hoping for two things: a Republican-controlled Congress, and improved CPI data. They only have one (for now), but that was enough for them to notch one of the best weeks since June.
- As might be expected, Treasury yields fell across the board as investors expressed hope that inflation has peaked and might soon head back down.
- Though there is debate as to whether this was just a temporary bounce, tech stocks made a comeback this week, with Meta improving measurably after announcing a round of job cuts on Wednesday.
We saw three major influences on the markets this week: the midterm elections, the weeklong drama around the collapse of cryptocurrency exchange FTX, and Thursday’s inflation-data releases. Ultimately, the market ended the week strongly. The SPX was up 5.88% for the week, the Nasdaq rose 7.78%, and Treasury yields fell, with the 10-year ending the week at 3.82%, down from 4.16% last Friday.
Monday saw markets rise slightly ahead of Election Day, with investors showing their enthusiasm for the prospect of a Republican-controlled Congress that, alongside a Democratic President, would mean a more frequently gridlocked government – widely believed to result in fewer regulations, lower taxes, and bigger corporate profits – and thus higher stock prices. SPX was up 0.1% and the Nasdaq rose 0.9%. Election Day saw the SPX up 0.56% and the Nasdaq up 0.49%.
Markets slid on Wednesday as the morning after investors saw control of Congress yet to be determined. The SPX fell 2.08%, the Nasdaq declined 2.48%, and the VIX rose to 26.01. Republican hopes for a dominating wave the night before did not materialize. As our US Policy expert Tom Block notes, most expect Republicans will ultimately win control of the House but without the overwhelming majority they had undoubtedly hoped for. After Democrat John Fetterman beat Dr. Oz in Pennsylvania, control in the Senate will depend on the results of a Georgia runoff between Herschel Walker and the Rev. Raphael Warnock, who got just a few votes more than the former football star, but not enough to pass the 50% threshold required by Georgia law. Senate races in Arizona and Nevada also remained too close to call as of Friday.
On Thursday, better-than-expected inflation numbers sparked one of the biggest single-day rallies since the pandemic began, with the SPX up 5.54% and the Nasdaq shooting up 7.35%. The two-year and 10-year Treasury yields each fell about 30 bps.
That rally extended into Friday, with the S&P500 and Nasdaq both rising (1.1% and 2.1%, respectively).
Crypto was sniffing out the bottom before this week, and ordinarily optimists might have had reason to hope for an imminent return to an upward slope – if not for the week’s dramatic events surrounding FTX. The cryptocurrency exchange’s now-departed CEO, SBF, is unlikely to find any allies in Washington, despite his previous efforts in the nation’s capital. Neither party is sounding particularly sympathetic, with House Financial Services Chair Maxine Waters (D-California) calling for increased crypto oversight, “Now more than ever, it is clear that there are major consequences when cryptocurrency entities operate without robust federal oversight and protections for customers,” she said. Ranking Republican on the Financial Services Committee Patrick McHenry (North Carolina), in line to become the Chair if the Republicans take control of the House as expected, did not sound any less severe this week: “The recent events show the necessity of Congressional action. It’s imperative that Congress establish a framework that ensures Americans have adequate protections while also allowing innovation to thrive here in the U.S.”
FTX on Friday announced it had filed for Chapter 11 bankruptcy. During the process, FTX will be overseen by John J. Ray III, a veteran liquidator who once helped to oversee the liquidation of Enron.
Disney plummeted after reporting quarterly results on Tuesday that missed Street top-and bottom-line expectations by a wide margin, and the House of Mouse also tempered forecasts for its next fiscal year (which runs from October 1 to September 30). On the plus side, Disney+ beat expectations for subscriber growth and record revenue from its parks, experiences, and products segment (though operating income fell short of expectations due to higher costs.)
As rumored earlier in the week, Meta on Wednesday announced it would lay off 13% of its workforce, about 11,000 employees. In a letter to employees, Mark Zuckerberg said the Facebook parent would also extend its hiring freeze through Q1. Meta’s stock, which had already risen significantly when the rumor began spreading, rose as much as 6.8% when it was confirmed. The Meta staff cuts, combined with the recent round of layoffs at Twitter and rumors that Salesforce quietly laid off 1,000 employees last week, have some observers talking about a bloodletting in the Tech sector.
Elsewhere in the world
China’s quest for zero COVID continued to focus on Guangzhou, with an estimated 5 million residents locked down as of Wednesday. In Beijing, 118 new infections – a minuscule number by global standards – also caused a new round of mass-testing and a limited lockdown of some buildings and neighborhoods in the capital city. On Friday, Beijing announced a slight loosening of its quarantining policies, though the country’s National Health Commission insisted that the country was not even close to "relaxing prevention and control, let alone opening up." Still, investors, desperate for even the slightest sign of progress back to normalcy, drove the Hang Seng up 7.74% and the Shanghai Composite up 1.69% in response to the revised quarantine rules. Oil prices also rose 3% in response to the news (and anticipated higher demand), with Brent crude futures rising 1.9% and US WTI crude gaining 2.3%.
Top Russian military officials announced on Wednesday that Russian forces would withdraw from Kherson City, a vital Black Sea port and the gateway to Crimea. Ukrainian officials initially expressed doubt about the sincerity of the announcement, but there was jubilation in the streets on Friday after Ukrainian forces entered the city and again raised their blue-and-gold banner. Kherson was symbolically important as the first major city Russian forces took over after their February invasion, and just a month ago, Vladimir Putin had declared Kherson to be a part of Russia “forever.” Russian forces remain in control of much of the region surrounding the city, however.
Sir Evelyn de Rothschild passed away on Monday at the age of 91. The scion of the storied banking dynasty was instrumental in the privatization of the UK’s nationalized oil, gas, and steel industries, leading the way toward a similar privatization of its coal industry and of British Rail.
These markets have been tenuous and harrowing. While Thursday’s rally was encouraging and while we take great pride in keeping you a step ahead of the crowd by rolling our sleeves up and getting under the hood on CPI, if you re-examined the aftermath of the Tech Wreck you will see that the Nasdaq had days of 6% up or more, you would have been wrong fourteen times if you assumed the bottom was in. There are plenty of reasons to be optimistic in the long haul, but war, plague, and a deterioration of global cooperation are all weighing heavily on markets.
Remember that if the market has a P/E of 17 then about 94% of the value is comprised of future earnings. When the future becomes less certain, so does the certainty about these future earnings. Then aside from all the prodigious risks we are facing, we are also facing pressure on multiples from the high rates after an extended period of low rates.
You might be wishing you could just set and forget your money with one of the best active managers in the world. Even here, the risks of self-deception and buying high and selling low can eradicate the good work of even the best active managers. Peter Lynch used to manage Fidelity’s Magellan Fund and had one of the best consistent track records of any active manager. He was prolific and he consistently beat the market and produced a stunning 29% annual return. Here’s the thing about mutual funds though, the individual investor still decides when to buy and sell their shares.
So, had they done nothing and spared themselves from their own emotionally driven mistakes they could have shared in Mr. Lynch’s prodigious returns. The great active investor himself pointed out that the average return of his investor was less than 25% of what he was able to deliver. Money would flow out during temporary setbacks and then chase the gains when he started to outperform. In doing so most investors missed the crucial upswing and the average return of a Magellan investor was only 7%, much closer to the long-run return of the market. So, remember as counterintuitive as it may seem, sometimes doing nothing is the most profitable approach to markets. Particularly if you don’t have algorithms on your side. The miracle of compounding has rewarded investors over time through all the risks and crises of previous decades and this will almost certainly continue.
Finally, as we mark Veteran’s Day in the United States, we pay tribute to all of those who have served our country and the world, and all of those who are serving today. Let us honor our heroes with both words and actions, ensuring that those who have sacrificed for freedom are always taken care of.
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A comprehensive overview of the nationwide mortgage market and covers all types of mortgage originators, including commercial banks, thrift institutions and mortgage banking companies.
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