Stocks, at least as measured by the Dow, suffered their biggest decline in two months. The two worst performers, United Healthcare and Home Depot#, were down after six straight record-setting new highs. I guess you could call that just good old profit taking. The NASDAQ, which has taken the brunt of recent selling pressure, rallied after declining close to 2% at the open. But the rally stalled before midday. Most issues simply moved sideways in the afternoon, hardly the sort of robust rally that could signal an interim bottom. Bonds fell slightly but remained within recent trading ranges.
Today’s big news will be this morning’s CPI (consumer price index report). The consensus is for a 0.2% increase ex-food and energy. That follows a 0.6% increase in March. Year-over-year the gain will be closer to 3.5%. But using last April as a base isn’t going to give a true sign of inflation. Last April was the peak quarantine period. Prices were heavily discounted. You could fly almost anywhere for $100 or less in a period when no one was willing to fly. But the sequential increase is important. A 0.2% increase will be treated enthusiastically. A 0.4% increase or higher will raise eyebrows from those fearing a serious inflation spike. 1-2 months don’t make a trend, but 1-2 months can start a trend. At any rate, the CPI report is likely to set the tone for today’s market.
Otherwise, it is more of the same. Cities like New York and Philadelphia expect to be completely open (with masks) within a month or so. Summer normally brings a slowdown in new contagions anyway as we all collectively move outdoors. Savings are high, money supply continues to grow at 20%+, the Fed is still buying $120 billion of bonds every month, and GDP is rising at about a 10% rate. You can’t do much better than that. Interest rates remain range bound even as inflation expectations rise toward 2.7%. At some point rates and expectations will have to correlate, but at the moment rates remain low, probably due to Fed intervention, and equity investors have little cause to be overly concerned.
That doesn’t mean all stocks are setting new highs. A lot of the crazy speculative stuff has begun to settle out. SPACs no longer are getting the same attention they were getting a few months ago. Digital art attached to NFTs aren’t selling for $60+ million. Bitcoin is moving sideways, not up. Hot new issues of the past few months, like DoorDash and Snowflake are setting new post-IPO lows. Some of the crazy names are no longer in outer space, they have reentered our atmosphere but remain sky high. The real bloodletting is still a future event.
Since last Fall, markets have rotated. Yesterday’s pain in the Dow and related names was a reminder that stocks don’t always go in one direction….up. One day of profit taking is barely a warning, but it is a reminder that valuation matters. That is true for DoorDash and for General Motors.
We are entering that quiet mid-quarter period. Today’s CPI report may be disruptive, but after that there will be little in the way of fundamentals that will change the market’s behavior. Q2 earnings are going to be spectacular, but we already know that and it is imbedded in stock prices. They key is whether future expectations will rise even higher once Q2 earnings are reported in July. The other factor is interest rates. For a couple of months, 10-year Treasuries have traded at a yield of 1.55-1.75%. If they stay in that range, that would be positive for stocks. However, if inflation expectations keep rising, rates will ultimately break out to the upside.
The bottom line is this:
1. Earnings expectations are high and already built into stock prices. They have to rise even further to support another leg higher. That’s possible but gets increasingly difficult over time. After Q2, the rate of improvement will begin the process of normalizing. By the second half of 2022, the rate of improvement should be back toward historic norms.
2. Interest rates remain contained. The Fed says current inflation spikes are temporary. There is a lot of skepticism whether that is true or not.
3. The speculative froth fostered by too much liquidity and Fed easing continues but seems to be settling down a bit. In time, most of today’s new companies won’t turn into tomorrow’s Teslas or Amazons. The graveyard will start to fill up.
In the meantime, valuation discipline is important. There are small pockets of truly undervalued stocks but most reflect a lot of optimism. With that said, growth will be above average through 2022. Some will have true breakthroughs.
Markets will continue to rotate. Many stocks moved too far, too fast, and need a breather. There is nothing wrong with periodic consolidation. Some of the speculative froth has worn off, as mentioned before, but there is more to go. If not now, it will happen in the months ahead. Remember that you own stocks not companies. Price always matters.
Skateboard legend Tony Hawk is 53. Emilio Estevez turns 59.
James M. Meyer, CFA 610-260-2220