Stocks finished mixed in a volatile session as investors digested a CPI report that didn’t offer much new information and was close to consensus forecasts. For those hoping for a continued deceleration in the pace of inflation, there was disappointment. For those looking for signs of either a soft landing or recession, there was little of either. In the end, stocks and bonds finished pretty close to where they started the day.
That doesn’t mean there wasn’t a message in the data. What we learned, if one strips out energy and food price fluctuations, is that the pace of disinflation appears to be decelerating? That shouldn’t be a surprise. The “easy” part was the impact of repaired supply chains. Short-term shortages caused spikes in prices that quickly returned toward normal once supply returned. Getting inflation back to 4% from 9% isn’t hard. Repairing supply chains and increasing the cost of money should do the trick, but the last percentage point or two won’t be as easy. Wages are still rising at a 4%+ rate and that isn’t likely to come down very quickly in a world with 3.4% unemployment. The cost of services, heavily tied to labor costs, will also continue to rise at a rate that is not conducive to price stability.
Thus, the new game plan (there’s always a new game plan, depending on the data) says 1-3 more small increases in short-term rates that might extend through the second quarter, and then nothing until there is a persistent and sustainable decline in the pace of inflation toward the Fed’s 2% target. That could take a few months. It also could take a year or longer. Unless there is a significant recession, the Fed will be under no pressure to reduce rates quickly.
How does this play out in the stock market? Many of the safe havens of 2022, the defensive names that stood up well like consumer staples, utilities, health care and energy, have been the weakest performers in 2023. Proctor & Gamble# is a great company, but should it sell at a higher P/E than Alphabet# or Home Depot#? Its price was elevated due to its safety characteristics in a bear market. Now it simply seems fully priced. Ditto for other consumer staples, drug stocks and utilities. On the other end of the spectrum are the growth stocks that led the market for the past decade. They were way overpriced in 2021 and had their comeuppance last year as interest rates soared and P/Es tumbled. In addition, when bear markets end (and it is quite likely last year’s ended in October) the first stocks to rally are the ones that declined the most. Some of the recoveries are legitimate. Investors overdo it on the downside just as much as they do on the upside, but some of the bounces are true dead cat bounces, companies that had growth stories (the sizzle) but lacked the fundamentals for long term success (the steak).
With the bear market likely at its end, and the dead cat bounces largely complete, one has to look at several factors. First, are long-term interest rates. Forget the Fed Funds rate. That doesn’t drive stock prices. P/Es key off of 10-year bond yields, or even longer. Stocks are long duration assets. The 10-year yield reflects the market’s vision for long-term inflation. Holders of 10-year bonds expect a positive return on their money, adjusted for inflation. If inflation expectations are 2.0-2.5% long-term (as they are now), 10-year Treasuries should provide lenders a 1-2% premium. That suggests long-term rates are within an expected range right now.
If long-term rates are anchored appropriately, then the future of stock prices will be earnings dependent. I still don’t know whether we are headed for recession or not. I have not deviated from that non-conclusion for over a year, but that suggests flattish earnings in 2023. Some economic weakness can be offset by managerial ability to adjust. In that environment stocks should move sideways until investors see an upturn in future earnings. Given that an upturn is inevitable, stocks will rise sooner rather than later. Maybe that is part of what has pushed stocks so far this year.
Another factor relates to the basic law of supply and demand. Last year, share repurchases were over $1.25 trillion, a record. On the other hand, new issuance via IPOs was a cyclical low of $487 billion. The gap of almost $800 billion doesn’t seem large against a total US stock market value of close to $43 trillion but it is. With a new 1% tax on stock repurchases (Biden’s wish for a 4% tax has no chance of passing), and the likelihood of a better IPO market, that tailwind will lessen.
Thus, long-term, I think trends are higher. They always are long-term, but near-term expect a more sideways market than we have seen year-to-date. Sideways means 5% moves in either direction are perfectly normal but more substantial moves in either direction need a fundamental cause most of the time. With earnings season largely over and the economy either growing or contracting very slowly, there don’t seem to be fundamental headwinds or tailwinds of note. That suggests either changes in fundamentals or simply momentum (now both positive and strong) will be drivers of stock prices near-term. An overlay, I keep harping on is valuation. Stocks are still historically expensive. Thus, without a justifiable tailwind, I remain cautious near term.
Today Megan Thee Stallion is 28. Matt Groening, the creator of “The Simpsons”, turns 69.
James M. Meyer, CFA 610-260-2220