Investment Insights

 — Steve Orr 

Break

One of the big drivers of stocks’ run since December is the hope that the Fed would soon cut interest rates. The Fed’s own projections of three quarter-point reductions in its Fed Funds target range opened retail and institutional wallets alike. Plungers have piled into index funds and the Magnificent 7 (4?), like the AI boom, would never end. Well, AI on a number of fronts is probably in the second or third inning. We’ll save that for a slow news day.

We are sticking with our call that this year will be a bumpy, but positive, ride for stocks, and you may encounter some buying opportunities in dips or corrections. Last Tuesday’s overreaction to a two-tenths increase in consumer prices was one such “opportunity.” The S&P 500, NASDAQ and Dow Industrials shed 1.5% to 2% in a day. By Friday, most of the action was forgotten as buyers pushed the indices to within fractions of their levels on Friday the 9th.  

For the mega-cap S&P 500, last week’s -0.35% (“flat”) return breaks a six-week positive run. Since the lows on January 4, the big index has risen 7%, the NASDAQ 8.8% and the Dow Industrials 3.4%. One does wonder if the current rally is a bit long in the tooth. We would note that the bulk of earnings season is over. A handy rule of thumb and consulting the S&P database shows that stocks generally post weaker returns in the second half of February. A few indicators show trends running low on fuel. Not enough to trip our indicators, but bears watching. One interesting historical note is that gains this large by mid-February have led to full-year gains 12 out of 12 times in the post-war period. 

Snap up

Inflation was the stated reason for the Fed to start raising rates a year late in 2022. By late 2023, the Consumer Price Index had reversed course and was running at a near 2% annualized pace. Please note history shows that CPI inflation always spikes up and down. The 2022-24 experience matches historical patterns to a T. The key is how far in the future and how high the next wave will be. Let’s start with 24 months from now and rising toward 5%. Write that down.

Traders had sweet dreams of coming rate cuts and were high-fiving the Fed. Lower interest rates mean cheaper debt costs and higher stock valuations. Ergo, higher stock prices. We have cheered from the inflation sidelines, watching our own costs of food, rents and medical care. Since Powell changed the narrative toward cuts, gasoline prices are 10% higher and Treasury yields some 40 basis points higher. Our anecdotal price checks seem higher than the reported numbers. We report, you decide.  

January’s CPI report poured cold water on every dream except AI. Yes, there are seasonal adjustments in January that can make the CPI report a bit out of sorts. The price increases were stronger than the revisions, however. Gasoline costs were down 6% year-over-year and home natural gas down 17%. Home heat was cold comfort to rising medical and auto insurance costs. Food costs continue to rise and restaurant prices clocked a 5.1% increase.

Producer prices, those paid between businesses and wholesale, also rose in December and January. PPI numbers are lower than CPI, rising at just 0.9%. The key for both data series is that they are starting to increase after bottoming last year. We cannot call this a trend just yet, but for the bond and stock Bulls demanding rate cuts, it should be a warning sign. They remain hopeful that the economy takes a sudden dip into flat or negative GDP growth. An economic speed bump would likely cause the Fed to panic and cut rates a couple of times into the summer. That would in turn cause a snap up in stock prices, along with a snap down in rates. GDP growth is slowing sequentially over the past two quarters. But we do not see recession-level flat or negative growth. Continued low unemployment and steady inflation is a recipe for no cuts — trader beware.

We would love to have Goldilocks 2% inflation and four rate cuts. Neither rosy outcome is in any of our scenarios. Call us myopic, but we are sticking with the concept that inflation has bottomed for this cycle. There may be flirtations with 2% in a recession in the next down cycle, but there are structural changes in our economy that will make a 3% level more the norm in the coming years.

Downside upside

Post-Valentine’s returns for stocks are usually on the weaker side — think of stale chocolate. The fourth quarter earning season is turning out to be a mild surprise that could help keep the big indices rolling higher. This Wednesday marks the last of the “Magnificent 7” to report. NVIDIA turns in its fourth quarter scorecard after the market close. Its shares are 47% higher since the beginning of the year and in 2023 rose 239%. If NVIDIA’s management is as upbeat as the rest of the tech sector, then late February could have more upside.

Back in Reality town, Home Depot and Walmart are due out on Tuesday. Their results and outlook will be a good read on consumer spending. HD and Lowe’s rode the goods inflation wave after shutdowns. Walmart is riding the current wave of services and staples spending.

Now that 79% of the S&P 500 have reported, we are on the downside of earnings season. Through last Friday, FactSet estimates year-over-year earnings grew 3.2%. That is at least three times better than the +1% hoped for at the beginning of the year. Revenues have grown for 13 straight quarters dating back to the end of shutdowns.