As I noted Wednesday, for Tuesday’s decline to have been meaningful, there had to be follow through Wednesday and beyond. There wasn’t. Over the course of two sessions, stocks recovered the biggest one-day loss since last March. At least in traders’ minds, the disturbing CPI report Tuesday was an outlier data point. Inflation is coming down to target, acknowledging there will be times when apparent progress is less than at others. The spike in bond yields that followed Tuesday’s reports hasn’t been entirely erased, but about half the increase was.
Markets aren’t always right. As noted on Wednesday, the CPI report does confirm a 3-month reversal in the pace of decline. Among service categories, inflation continues to be persistent. I offered a list of items within the CPI report that increased at an annual pace of at least 6% in January. The list is long beyond the imputed rent number that so many choose to ignore.
Markets reflect a combination of inflation expectations, which anchor the P/E ratio, and earnings growth. Even as earnings season winds down, we get mixed messages from corporations. Over the past 24 hours, we saw better than expected results from Uber and modest disappointment from Door Dash. Both are largely in the same businesses. Deere, the huge agricultural equipment manufacturer, offered a dour outlook for the rest of 2024. Many companies site weakness in China. But not Applied Materials, the big manufacturer of equipment to make semiconductor chips and solar panels. It sighted strong demand from China in particular. This is what happens in an economy with a flattish outlook. Companies more in control of their own destiny thrive while those used to riding the wave of overall economic growth falter. For investors the message should be clear. Find companies that either persistently gain market share through superior execution, or who operate in sectors with an expanding total addressable market (TAM). Companies seeking to use AI as their next growth platform are obvious examples.
Overlaying all this is a rise in speculation. Bitcoin, the ultimate indicator of speculative activity is closing in on all-time highs. Technical indicators for many of the tech high flyers are sending out loud alarms that these stocks are overbought. That doesn’t mean they are about to crash, but it does mean that some sort of correction is likely. Again, that’s a valuation issue, not meant to damn any of the fundamentals. But perhaps the biggest indicator of a true surge in speculation is the action surrounding Digital World Acquisition Corp (DWAC), a SPAC born a few years ago to acquire the parent company of Truth Social, the Social Media platform Donald Trump has used since being kicked off Facebook and X. While the latter two now allow Trump back, he has stayed with Truth Social. One reason could be his roughly 60% ownership in the platform. This week the SEC cleared the ability of Truth Social’s parent to merge into DWAC after fining the latter for a myriad of actions and misstatements from the past. DWAC’s stock has tripled this year, as speculators surmised that the coming Presidential election will send more eyeballs its direction. Never mind that losses are three times revenues, that Mr. Trump may choose or be forced to sell his stake, and that advertisers, the primary source of revenue, just may be hesitant to get too close to some of Mr. Trump’s more outrageous postings. Never mind that the merger may never happen as DWAC is running out of cash. Sure, one can draw a path to survival or even success. But it’s a path dotted with ifs and suppositions that all have to come together. DWAC had its day in the sun two years ago when SPACs were the rage. Markets haven’t gotten to that level of speculative fever yet, but they are on the way. Don’t forget that in the end, valuation matters. Bulls offer the suggestion that P/E ratios today are nowhere near their 1999-2000 peak before the Internet bubble burst. But they don’t have to be that outrageous for one to raise the caution flag.
With all that said, the economy is humming along although retail sales took a hit in January in part due to nasty weather. Just as momentum traders were willing to ignore Tuesday’s CPI report, they quickly sloughed off the poor retail numbers yesterday putting all the blame on bad weather.
Quite a few years ago, I listened to a lecture from a Yale law professor on game theory. Without getting too deep into the weeds, his cogent point is that we all want to find information that confirms our thesis, where the right approach is to search for information that disproves our purported conclusion. For bulls, casting aside the CPI and retail sales reports as distortions may prove correct as subsequent date reaffirms the thesis that a soft landing is near while inflation slides toward 2%. But skeptics take note in a different way. They see CPI gradually rising over the past three months as wages put pressure on service costs and strong demand allows service providers to pass along the added cost to consumers. Skeptics note the bad January weather impacting retail sales but also note the decline in the savings rate and the rise in credit care delinquencies as warning signs.
This week’s data neither confirms or discredits either side’s conclusions. But the data certainly, at a minimum, does not confirm the bull case. The data should raise eyebrows. On Wednesday, government and Federal Reserve officials came out strongly to support the conclusion that everything was still in order and the glide path favored a soft landing with moderating inflation. That’s what a large drop in the stock market will do. But by yesterday, there was less of that. Look, the Fed is trying to engineer a soft landing and an ultimate target of 2%. It isn’t about to criticize itself until data overwhelms its thesis. Remember when the Fed’s favorite word was transient? It took several months of accelerating inflation to force a change in language. While supply chain problems which exacerbated inflation were key to a spike witnessed over the past two years, getting inflation from 3-4% to 2% is going to be more of a challenge. Today, supply chains are largely back to normal while inflation stays above 3%. To be sure, there are signs in favor of lower inflation. Productivity is rising. Manufacturing capacity utilization is comfortably below 80%. Import prices are in decline. Today’s PPI report could help to support the case that inflation is slowing, recognizing that PPI data impacts the cost of goods much more than the cost of services.
Thus, as stock markets once again appear ready to surge to new highs, traders are ignoring the clouds. Stocks are priced for a soft landing, moderating inflation, improved productivity and a resurgence in earnings growth. All possible, maybe even likely. But Tuesday was a reminder that smooth sailing isn’t the only possible outcome. Next week, Nvidia# reports on Wednesday after the close. It is likely to be the single most watched earnings report this season. Its stock price has shot up in advance. Everyone knows the news is going to be good. The only question is how good. Will results match expectations? Will results exceed enlarged expectations and, if so, by how much? Supporting the growth in AI requires companies to spend heavily not only to grow computing capacity, but literally to rebuild it centered around GPUs rather than microprocessors. That’s a lot of spending a lot of which will accrue to Nvidia. We will get the market’s message quickly next Wednesday. The reaction will quickly spread, for better or worse, to the rest of the tech complex.
Today, John McEnroe is 65. Carl Icahn turns 88.
James M. Meyer, CFA 610-260-2220