- Inflation remains high, but it headline CPI decelerated in July.
- Earnings are falling, resulting in a lower earnings outlook for the rest of the year.
- The Fed's likely to remain unfriendly, so stay "cautiously" optimistic.
Everyone knows inflation is a problem. We’ve heard that drumbeat for months. Perhaps, it’s because the “inflation is bad news for stocks” argument has become so widely adopted that we’ve been able to climb the wall of worry since mid-June.
On Tuesday, the Bureau of Labor Statistics gave us our latest taste of inflation’s impact on consumers when it released the Consumer Price Index (CPI) for July. While the Personal Consumption Expenditures Price Index (PCE) is the Fed’s favored inflation measure, CPI gets truckloads of media attention, making it a key influencer of Main Street sentiment.
The data wasn’t great, but it wasn’t a train wreck either.
Inflation cools in July
Headline inflation, including energy and food, increased 8.5%, lower than June’s 9.1% pace and slightly slower than the 8.7% analysts anticipated. If we strip away energy and food, core inflation was 5.9%, in line with last month and below the 6.1% analysts forecast. Core did tick up 0.3%, however, from June.
Stocks rallied sharply on the data, ostensibly, because moderating inflation bolsters the chance the Fed pauses later this year. The odds of a 0.75% hike in September dropped to 40.5% from 68% today, but we should remember that the odds were 31% one month ago. A lot can happen between now and next month’s meeting, so I suspect the odds will be volatile.
In “What the July CPI Data Shows,” Action Alerts PLUS co-managers Bob Lang and Chris Versace remind us that “for the end of 2022, fed futures still predict a 3.5% funds rate, so a total of 1.25% more in rate hikes from current levels.”
That still suggests an unfriendly Fed, so we probably don’t want to get too optimistic.
According to Lang and Versace, “In terms of the Federal Reserve and its next course of expected monetary policy action, the July CPI report showed some progress but not all that much. Taken together with the hotter than expected wage inflation in the July Employment Report, it likely means the Fed will continue to fight inflation.”
Digging deeper into the CPI data shows a lot of the lower-than-expected top-line figure was because of recent relief in highly-volatile oil and gasoline prices.
In July, energy commodities declined 7.6%, while gasoline and fuel oil retreated 7.7% and 11%, respectively. It will be interesting to see if lower prices at the pump translate into an improvement when the August preliminary Michigan Consumer Sentiment survey is released Friday.
The Producer Price Index – a measure of wholesale inflation – should also be instructive tomorrow.
In June, PPI gained 1.1% month-over-month and 11.3% year-over-year, the second highest reading on record. If PPI remains stubbornly high, corporate margins could get squeezed further if they're unable to pass along higher costs to consumers.
Earnings are falling
In Q2, corporate margins narrowed because wage growth is trailing inflation, making it harder to raise prices. According to Factset, S&P 500 second-quarter earnings grew 6.7%, with 87% of companies reporting. That's the smallest increase since the COVID-hampered fourth quarter of 2020. The earnings growth is worse, however, if you remove energy stocks. Excluding energy, S&P 500 earnings fell 3.7% in Q2.
Since earnings are declining for non-energy companies, estimates are falling, too. Analysts now expect S&P 500 earnings growth of 5.8% for the third quarter and 6.1% for the fourth quarter, landing full-year earnings growth at 8.9%. In mid-July, they were looking for 10.1% in Q3 2022, 9.2% for Q4, and 9.9% for the full year.
Again, energy stocks heavily influence analysts' outlook. Excluding energy, growth drops to 2.4% this year. Given the positive impact on S&P 500 earnings, it wouldn’t be a stretch to think full-year earnings outlook from the S&P 500 could come under additional pressure if commodity prices keep falling.
The Smart Play
Stocks are a leading indicator, and historically, individual stocks bottom before the market, and the market bottoms before a recession ends, when economic and earnings news are at their worst.
Many stocks put in their year-to-date low in May, before the S&P 500’s year-to-date low in June. Undeniably, the economic news is lousy, and earnings are heading lower, yet investors are buying, rather than selling, bad news, and that’s encouraging.
Still, caution flags remain, so active investors should be defensive. It takes time for actionable bases to build and stocks to digest trapped sellers lurking above at higher prices.
In “Will the Bears Pass or Flunk a Retest?” Top Stocks Helene Meisler shares one of her favorite charts, a ‘typical’ pattern of bear markets, from her mentor, technical pioneer Justin Mamis. History doesn’t repeat, but it often rhymes (to paraphrase Twain), so where we decide we are on this chart can be helpful. Of course, it’s more art than science, but Meisler writes, “Back In June, I said I thought we were at Discouragement when it came to growth stocks. I think now we're in that Wall of Worry on our way toward Anxiety.”
If so, then we could experience, at a minimum, some backfilling of our recent gains.
Overall, the recessionary baskets (healthcare, staples, utilities) continue working, so that’s still the focus. As I’ve already written, the energy trade is a bit long-in-the-tooth. Its best performance happens during the late stage of the business cycle when inflation is increasing. Therefore, use stop losses and keep a tight leash on them. As for early cycle stocks, like technology, they're showing signs of life in anticipation of a friendlier Fed next year. While that’s encouraging, it doesn’t mean the S&P 500 is out of the woods yet, so active investors should concentrate on buying individual stocks near support rather than chasing them at resistance. Note: This Credit Suisse report is an excellent resource if you want a refresher on support and resistance lines.
If you're a long-term investor, remember, there’s never been a bear market where it hasn’t paid to increase how much money you dollar-cost average into the S&P 500. Therefore, if possible, increase your contribution amount so you'll own more shares and lower your average cost, allowing you to recover your drawdown more quickly.