Inflation Remains The Hot Button of Both Stock and Bond Markets

Inflation Remains The Hot Button of Both Stock and Bond Markets

May 15, 2024

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When I read the weekend press, I pay attention to several things. Is there turmoil to talk about? Are there earnings to talk about? Are there conflicting economic reports coming out that require us to be prepared for different possible outcomes? This weekend the press was about retirement. What does it mean to you? Should you work longer? Did your spouse pass? Basically, there was so little to discuss that there was the need to find subject matter that had some meat on the bones. What I found particularly interesting was stated by Ryan Detrick of Carson Research Group. According to Detrick, the S&P 500 is up 3.75% so far in May, through Friday, and the Dow Jones Industrial Average was up each of the first eight trading days of the month. This amount of change, in and of itself, does not seem particularly important until upon researching this, it is the longest winning streak to start the dreaded month of May EVER! So according to Detrick, the "Sell in May and Go Away" clearly doesn't apply to this year. 

Since the end of the 5.5% pullback in prices into April 19, the index rose a shade more than 5% and as of Friday was less than 1% away from setting its 23rd new high of the year. Consistent with history, this sub-6% selloff has taken less than a month to approach full recovery. Even more encouraging is that history suggests that over the coming three-plus months, the index could register an additional 5-10% gain above the prior high before slipping into another digestion period. Many attribute this bounce back to the Federal Reserve's change in direction. In their comments, they have removed the risk that the next monetary move will be a rate hike. It is suspected that this is the reason for the bounce back last week. This bounce back reflected that 91% of all sectors were stronger for the week. Although the week was only up 2%, not only was it a continuation of the record-setting May advance, but the advance showed tremendous breadth as almost all sectors joined the rally party. 

The really strange thing is that according to Hedge Fund Research's positioning data, the data now shows aggregate stock market positioning by their hedge fund’s research to be short. The majority of hedge funds are actually investing in an expectation of a market decline. When major stock indexes rally following negative positioning such as this, it raises the probability of short covering for those who find themselves on the wrong side of the markets' momentum and they must compound the buying pressure by reversing their short positioning. It was also mentioned that last week had some of the lowest trading volume. The S&P 500 has never had two back-to-back closes under 39 million shares traded until Friday going all the way back to the year 2000. As the old saying goes, "One should never short a dull market!"

This makes me ask myself, "So, what are hedge funds and negative market nabobs thinking about that makes them expect market negativity?” These were the points that jumped out to me since last week's letter:

1. The market is for the most part dependent on the strength of the economy, and the strength of the economy is often reflected in the job market. In perusing the earnings reports of the companies in the S&P 500 I scanned for the number tightening labor sentiment comments. As can be seen below, the number of comments is back down to COVID times of late 2020. This doesn't seem to scream inflation fear to me.

2. Another point that I chose to focus on is the action of the consumer. Since consumption is around 75% of the entire economy, the action of the consumer and their savings rate often gives a clue to what is happening with consumption. The first negative consistency was that major discretionary companies are guiding lower going forward in their earnings projections. The support for consumer spending from savings accumulated during the pandemic is winding down. NDR Research's estimate of excess savings, based on a deviation from the pre-pandemic trend in savings, has come down steadily over the past two years, reaching the lowest level in this cycle.  Maybe the $6 Trillion in cash sloshing around on the sidelines is starting to show signs of losing its discretionary purchasing power:

3. The next logical question is how is the consumer making their purchases? Are they using cash or credit? Since there are really no ways to measure the amount of cash purchases, I follow what is happening with credit. The consumer has not just benefited from all the free cash thrown around by the US Government, but also from the housing wealth effect. These have likely facilitated the runup in consumer debt. Household balance sheets, however, are still in good shape, with real average net worth higher than pre-pandemic levels. Yet, consumer loan delinquency rates picked up in Q4 of 2023, to the highest it has been in 11 years. This could suggest some financial stress emerging, which could weigh on consumer spending as well:

All of this brings me to the observations of Thomas Lee of FundStrat. According to Lee, his bullet points for why he believes the markets should have a good inflation report result this week are as follows:

  • A "dull week" in the markets suggest investors and hedge funds de-risked in April. These same investors need to re-risk now. This could be a result of the red-hot economy thesis being in question.
  • Many pundits and strategists who argued for "the top is in" for 2024 and wanted to begin the "Sell in May" are being forced to reverse and buy in May.
  • The dreaded inflation reports of Producer Prices (PPI) and Consumer Prices (CPI) might not be as hot as feared. This could cause the number of expected Fed rate cuts to increase and be telegraphed in lower levels for interest rates. 
  • The two culprits for the hotter than expected CPI numbers have been auto insurance and rents. Should these two simply moderate instead of being red hot, CPI could be more tame. 
  • Q1 of 2024 earnings were the strongest beats since 2021. 
  • The 4% decline in April burned off the froth of the October 2023-March 2024 run and reset the risk vs. reward in the market levels. 
  • April 15th was one of the largest "Tax Day" withdrawals and this de-levered investors in April. 

In conclusion, when stock indexes have a positive result in the first quarter, and a negative April, within an overall market advance, there has been a high probability of a higher May since 1985. The economy, as shown above, is no longer red hot, therefore the Fed has stopped warning of additional hikes and seems to be cracking the door for more and sooner cuts. And this is all in the face of the highest Q1 earnings since 2021. 

- Ken South, Newport Beach Financial Advisor

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