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  • CPI shows inflation decelerated to 7.7% in October from 8.2% in September.
  • The data suggests the Federal Reserve's next interest rate increase may be smaller than this year's previous increases.
  • Stocks rallied sharply higher on the news, led by technology stocks.
  • Watch October's core PCE data on December 1st for signs of confirmation that inflation is slowing.

Expectations for stocks were low ahead of this morning’s Consumer Price Index (CPI) report. Perhaps, too low.

The Bureau of Labor Statistics headline CPI for October printed at 7.7%, below September’s 8.2% reading and economist’s forecasts for 8%. In addition, the core CPI, which removes volatile energy and food costs, clocked in at 6.3%, below the 6.6% predicted by Cleveland Fed’s highly-watched Nowcasting tool.

Driving the better-than-expected numbers were a decline in the cost of goods and a slower-than-expected rise in services. That was enough to spark optimism that the Fed’s hawkish pace of rate increases would cool, sending investors scrambling to cover short positions.

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Growth stocks were the biggest beneficiaries.

The technology-heavy NASDAQ 100, which had seemed destined to retest 52-week lows made earlier this month after failing to hold its 21-day moving average on Tuesday, surged over 7% higher today. Software stocks highly dependent on foreign sales were particularly strong performers because the inflation print caused a tumble in the U.S. Dollar.

More defensive-oriented baskets, including healthcare, didn’t perform as well as technology, but they still gained ground. As a result, the more diversified S&P 500 jumped over 5%, while the small-cap Russell 2000 added more than 6%. Most stocks traded higher in early action, with New York Stock Exchange advancers totaling 90% at 11 am.

The rally in technology stocks is a good reminder that betting against high-beta growth stocks can be painful in a mature bear market when the reasons for shorting them become mainstream. When that happens, tilting contrarian can be the best bet, as we’ve witnessed today.

In his Real Money Pro diary, Doug Kass, a self-described contrarian with a calculator, says he’s become more bullish on the sector lately:

“Over the last several months, I have noted that the Bear Market decline was beginning to create an opportunity to buy great companies at good prices…One new area I have begun to embrace is large-cap technology. The decline in big tech has accelerated in recent weeks, and with every downtick, I am buying incrementally…The daily drubbing in FAANG + M makes it hard for many to understand my buying - especially those that are guided by price and price momentum…There are numerous reasons for my renewed optimism in this much-hated space…As I recently wrote to our Limited Partners, our repeated refrain continues to be sung -- we are buying great tech companies for good prices.”

Indeed, Kass’ go-against-the-herd approach paid off (note: I’ll be providing a lot more insight into Kass’ thinking in tomorrow’s edition of Smarts.)

What inflation means for stocks now?

The “Don’t fight the Fed” mantra coined by Martin Zweig has proven true again in 2022. The Federal Reserve’s transitory inflation talk last year meant it was late to the inflation-fighting party this year. As a result, it’s been playing catchup, raising rates faster than in decades while forcing bond rates higher by not replacing maturing Treasuries on its balance sheet.

I’ve shared this table from Zweig’s Winning on Wall Street many times with Smarts readers this year. It shows that the best stock market returns occur when the Fed is aggressively loosening (extremely bullish) rather than tightening (extremely bearish). Until the Federal Reserve signals it’s confident its tamed inflation, stocks are likely to face a steep uphill climb.

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Today’s inflation data is encouraging, but it could still be a while before inflation retreats to levels consistent with the Fed’s 2% target.

In October, shelter accounted for over 40% of core inflation’s change, led by rent and owner’s equivalent rent (OER) expenses, which lag because of how they’re calculated. Rental rates usually adjust at the end of one-year leases, and OER trails actual changes in home prices. So, the CPI’s shelter component is a delayed reflection of what’s happening in the housing market.

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It may take time, but surging mortgage rates slow home buying activity, which should soften home prices. If so, shelter will be less inflationary next year when it becomes harder to eclipse this year’s comparisons.

In the meantime, other CPI inputs argue more forcibly that the Fed’s hawkishness is starting to pay off. For example, the month-over-month change in food has been declining since May, reaching its lowest level since December last month. Year-over-year energy inflation remains high at 17.6%, but the pace has decelerated. Used car prices, which contributed to higher inflation previously, fell 2.4% from October. There are green shoots.

That’s likely why expectations shifted today for the size of future central bank rate increases. The CME’s FedWatch tool shows an 80% probability of a 0.50% increase next month rather than another 0.75% increase. Yesterday, the odds were relatively split for a 0.50% or 0.75% hike at 57% and 43%, respectively. The outlook for rates in May 2023 dropped too. One week ago, there was a 32% probability the Fed Funds rate range would be 5.25% to 5.50%. Today, it’s below 7%.

If, and this remains a big “if,” inflation data continue cooperating, allowing the Fed to move to the sidelines, then perhaps, stocks can move higher. However, a lot can still happen, and CPI isn’t the Fed’s preferred measure of inflation. That trophy goes to the Personal Consumption Expenditures index. We’ll get the next core PCE data on December 1, before the Fed’s next meeting on December 14th. If that data confirms the CPI data, it will add conviction that the Fed will ease its foot off the rate hike accelerator. Currently, the Nowcasting model is projecting core PCE for October will be 5% versus 5.1% in September.

The Smart Play

It wasn’t long ago that rock-bottom Treasury yields left investors with few alternatives to owning stocks.

Now that the easy monetary and fiscal policies of 2020 are over, soaring yields mean Treasuries are competing for shareholders’ attention again.

For this reason, investors will want to keep tabs on how Treasuries perform because lower rates could stimulate higher stock prices and vice versa. For example, the 20-year Treasury ETF  (TLT)  surged nearly 3% today, taking pressure off stocks.

Investors should also watch the U.S. Dollar Index ETF  (UUP) . A hawkish Fed has fueled the steady rise in the Dollar this year, hurting financials at U.S. multinationals and technology stocks, which generate 59% of their sales overseas. The Dollar weakened after today’s inflation report, providing another tailwind for stocks.

Overall, one data point isn’t enough to force a Fed pivot. However, if PCE confirms that inflation is slowing, the Fed will likely slow its pace of increases, which is an important step toward a friendlier policy. Undeniably, CPI at 7.7% in October shows inflation continues taxing consumers' wallets, however, increasingly, investors should focus more on the rate of change in inflation rather than its level because that's what's likely to move stocks at this stage of the bear market.

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