Inflation report
Yesterday’s headline CPI inflation report posted a 2.7% rise for November, driven by price increases in goods such as cars and furniture. The report showed inflation remained steady with core CPI (i.e., ex food and energy) at 0.3% month-over-month and 3.3% annualized. Shelter inflation moderated slightly, while increases were seen in food and used vehicles. This morning’s PPI report of +0.4% was 0.1% higher than expectations. Nonetheless, this data will likely not have an impact on the expectation for a December Fed rate cut, but next year’s cuts are not so certain if inflation remains stubbornly above the Fed’s 2% target.
However, the market faces various pressures beyond monetary policy. This presents a challenge for the incoming Trump administration, which has promised to reduce inflation, and for the Federal Reserve, which is considering further interest rate cuts. Economists are concerned that tariffs and persistent inflation in the services sector could make it harder to bring down prices.
Despite some positive signs, such as a slight cooling in housing cost increases, consumer and business confidence remain high, which could contribute to further inflationary pressure. While businesses report that inflation is normalizing, some economists warn that the “last mile” of reining in inflation will be the hardest, requiring a weakening of demand in the economy.
Stock market momentum continues
The S&P 500 has shown strong performance this year, but warning signs are emerging. The index’s current price-to-earnings ratio is historically high, comparable to levels seen before the dot-com bubble burst and the COVID-19 market crash. Despite consumer optimism, this suggests the market may be overvalued and due for a correction. Historical data indicates that when the S&P 500’s price-to-earnings ratio exceeds 23 times, future returns tend to be lower over a multi-year period. Unfortunately, this same historical data is not a reliable predictor of exactly when the stock market will sell off.
Market cycles rhyme, but there are always differences that cause investors to think it’s different this time. Sometimes those differences are real and cause historical patterns to fail. Today, we have a combination of relatively low unemployment, modest earnings growth, and interest rates at moderate levels. Fueling the stock market is extreme optimism surrounding AI investment opportunities and record amounts of liquidity in the hands of investors. Moreover, demand for stocks from corporate buybacks and retail investors’ increasing appetite for equities is not being met by new stock issuance from IPOs or other sellers. Thus, prices go higher.
Market valuations are high and investor optimism is at a record level. A market correction is overdue, and several factors, including potential trade wars and geopolitical risks, could derail current momentum. Furthermore, the market seems to be overly reliant on positive expectations for the incoming Trump administration’s policies. While tax, tariff, and regulation changes could boost the market, the path toward implementing these changes is likely to be complex.
Potential trouble ahead
Investors appear to be overlooking potential challenges and focusing solely on the positive outcomes. Trump’s Department of Government Efficiency (DOGE) has big plans, but what actually gets accomplished in terms of deficit reduction remains a big unknown. Expectations for economic benefits from manufacturing reshoring and foreign direct investment are also supporting investors’ optimism. However, these potentially positive economic themes may, in fact, cause an increase in the demand for goods/services. In recent surveys, it has been reported that small business owners are particularly upbeat based on expectations of lower regulatory costs and taxes. This jump in small business optimism may counter the Fed’s aim of cooling inflation.
In fact, yesterday’s inflation report may have been in line with expectations, but it also suggests that inflation is no longer decelerating at a pace to reach the Fed’s 2% target anytime soon. A few more reports like this will not be welcomed by markets if they cause the Fed to unexpectedly put its rate cut plans on hold.
Despite these concerns, the outlook for 2025 corporate profit growth remains generally positive, especially if economic fundamentals stay strong. According to published analysts’ projections, companies are expected to grow their profits by approximately 14% next year which is on top of a near 10% gain this year. Time will tell if analysts’ projections are overly optimistic. I suspect earnings growth will be positive, but lowered to more realistic levels based on recent corporate earnings releases and management commentaries.
Investors should proceed with caution and maintain a well-balanced investment strategy given the two consecutive years of double-digit gains which has led to very high stock valuations. Stock price gains have far outpaced the actual earnings growth delivered by companies. This can’t continue forever. A realistic assessment of potential risks and challenges is crucial for navigating 2025 which is likely to be a more volatile year than we have witnessed in 2024.
Singer Dionne Warwick turns 84 today, Olympic gymnast Cathy Rigby is 72, and actress Mayim Bialik turns 49.
Chris Gildea, Co-CIO, 610-260-2235