QVMS - August CPI: The Moment Of Truth For Stocks

Summary

• The near-term future of the stock market hangs in the balance with the August consumer price index report, due out on Tuesday, Sept. 13, at 8:30 AM Eastern Time.
• The latest inflation report is a report card for the efforts of global central banks to rein in inflation and restore normality to the economy.
• A bad inflation report for "core" CPI will likely send stocks tumbling in the aftermath, while a good report would reassure jittery markets in a historically weak time of year.
• My thoughts on where CPI will land and the general risk/reward proposition for the market.

Inflation has been out of control in 2022, so far mostly defying the coordinated global effort by central bankers to bring it down. The annual rate of inflation in the United States peaked in June at 9.1% but is sitting at 8.5% year-over-year as of the July report. The headline swings of inflation are important but more critical for Fed policy and markets is the "core" rate of inflation that excludes volatile components like food and energy. This week, the Fed gets another report card when August CPI is released at 8:30 AM on Tuesday. The next step comes when the Fed meets again from Sept. 20-21 to decide the future path of interest rates. September is historically the worst month for stocks, adding to the potential drama. As of my writing this, stocks are staging a rally going into the report tomorrow, but I don't trust it.

In 2021, the broad S&P 500 Index ( SPY ) soared. The Fed insisted that inflation was "transitory," interest rates were pegged at 0%, and prices rose much more quickly than household incomes, causing the underlying standard of living in America to fall. With free government money, everyone wanted to eat and no one wanted to cook, driving prices higher and higher. If you overpaid for anything in 2021, then welcome to the club! In 2022, the fiscal and monetary stimulus is gone, central banks are hiking rates at unprecedented speed to get inflation under control, and global stocks ( VEA ) have fallen by around 20%, with the US doing a bit better. This places prices back towards where they were before the pandemic when money wasn't free.

Where Is Inflation Headed?

Economic models are showing that the headline CPI number likely will be about flat from last month due to lower gasoline prices, but the real drama and intrigue will come from the core CPI numbers, which are expected to be fairly hot at around 0.5% month-over-month.

The markets rallied before and after the July CPI report released last month. July CPI came in better than expectations. But this enthusiasm may be short-lived. Consider that July CPI came in better than expected after June's stock market rout and mortgage interest rates hit their first high of the year around 6.25% . This meant the dollar was stronger (this directly makes imports cheaper!) and all the crazy speculative sources where people were getting money from were all cut off; like altcoins ( DOGE-USD ), NFTs, cash-out refinances, HELOCs to buy cars and boats, and meme stocks like AMC Entertainment ( AMC ) and Bed Bath & Beyond ( BBBY ). But after the lows in June, the market staged a 17% bear market rally led by the most speculative names, echoing the big bear market rallies in 2000 and 2008.

Interest rates plunged as market participants hoped the Fed would pivot and cut rates, and the dollar weakened. The idea here is that all of this loosening of financial conditions set the scene for people to turn around and spend big. Powell smacked down this idea at Jackson Hole, sending stocks plunging. Now they're starting to rally again. Thus, there's the risk of a core CPI to surprise to the upside for this report and for another stern Fed meeting, and for stocks to sell off. In turn, when the CPI report for September comes out in October, higher interest rates and lower stock markets might allow stocks to briefly rally unless traders figure out the cause and effect.

Commodity disruptions are thankfully easing, erasing some of the price surges from the war in Ukraine. This is a good thing. Unless you don't drive, you've likely noticed that gasoline is cheaper now. The fear was that the war would totally disrupt global supplies of grain, oil, and natural gas. What actually ended up happening was that Russia ended up selling a lot of its oil to neutral countries like India, and ended up more or less stealing grain in occupied territories to sell to the Middle East. At the same time, some diplomatic efforts were made and Ukraine has been able to sell grain from its side of the frontlines as well.

But the crux of the issue here is that the Fed was never going to set interest rates to try to offset supply shortages (otherwise rates would be at like 9%!), but rather to target "core" inflation with interest rate hikes and QT to balance supply and demand. This has always implied a necessary interest rate of somewhere around 4% that will last for a year or more, much to the dismay of market bulls . And there are some technical issues that have to do with lease renewals that will make CPI inflation in all likelihood harder to get down to than anyone would like. Core inflation is where the problems are and will be the likely catalyst for the market's reaction to the inflation report Tuesday.

It's possible that the numbers show that inflation will go away without the Fed needing to hike rates, but I wouldn't bet on it. Inflation has broadened and become more entrenched in the economy. The post-pandemic YOLO mentality has proven to be entrenched in the psyche of consumers who have had no issues with running up credit cards and spending down savings built up during the pandemic. This dynamic is setting up a potential showdown between consumers who are determined to spend and the Fed. The Fed would like to take the opportunity for some macroprudential policy . In plain English – there's a lot of money sitting in banks right now, and the Fed would prefer that people don't try to spend it all at once and drive up prices. Instead, the Fed wants to raise rates to give an incentive for people to spread it out. If you're willing to delay spending your money until the supply chain can heal more, the Fed has decided that you'll be able to earn some nice interest in the meantime.

One thing that may make the Fed's job harder here is that consumers are used to getting 0% in interest from banks and don't realize they can earn interest on cash anymore. Instead, the Fed hikes rates, but banks pay zero, so the underlying incentive for consumers remains to spend big and live for the night. And it's the same in the stock market. This makes it hard for the Fed to stop the YOLO mentality through slow, calculated rate hikes. When the Fed first hiked 75 basis points the market interpreted it that Powell wasn't serious, forcing the Fed to do more. Expect a hot core CPI on Tuesday followed by a 75 basis point hike from the Fed. The Fed may be forced to shock the markets with larger-than-expected rate hikes and QT policies to pull enough money out of the system to force businesses and consumers to change their habits.

Where Are Stocks Headed Next?

Against all odds, Q2 2022 was the best quarter in American history for corporate profits. S&P 500 components earned $57.78 for the quarter, beating even the holiday quarter from 2021. Bears had warned that profits would fall as consumers felt the squeeze from gas, food, and rent rising faster than their wages. They did, but to my earlier point, this didn't slow spending for consumers who were sick and tired of COVID lockdowns. Bulls generally believe the economy is structurally better post-pandemic. This will be widely debated, but it seems clear to me that corporate profits can't continue at this breakneck level forever, and that increased government debt limits the ability of the government to stimulate the economy.

The Fed's interest rate has just begun, but cracks are showing in interest rate-sensitive areas. The housing market was the biggest beneficiary of the crazy pandemic QE, and it will take the hardest hit going forward from QT and rate hikes. And far too many companies over the past decade have built their entire business models around zero interest rates. Profitless " zombie companies " won't be able to survive in a free market, and that's going to be an adjustment. There are still good stocks to be bought, but patience is a virtue.

I don't believe the pandemic lockdowns and stimulus unlocked the keys to prosperity that were somehow hidden away during the 2010s when the economy was normal. The ongoing railroad/union negotiations ( and potential strikes ) are a textbook example of how profit margins are unsustainably high and inflation will be hard to stop. Without massive stimulus and QE, corporate profits probably need to go back to around where they were in 2019, plus the growth in nominal GDP. GDP should end the year about 15%-18% bigger in nominal terms than it was in 2019, so this implies S&P 500 corporate profits going back to around $200, or a bit less. Large-cap stocks have generally traded between 15x and 18x earnings , so this implies a fair value for the S&P 500 on the low end of somewhere between 3000 and 3600. As of my writing this, the S&P 500 trades for a little above 4000, implying an overvaluation of 10%-25%. My best guess is that the fair value of the S&P 500 is around 3300. If you want to make much money long-term in stocks, you need this extra compensation for the long-term issues that face the world in the form of lower prices!

What's The Game Plan?

I believe stocks are still overvalued, and the recent rally seems speculative. The market is more or less being led by Cathie Wood's Ark Innovation Fund ( ARKK ), up about 12% for the last week. I would be patient here and keep some powder dry.

You can get a little over 3% from buying 3-month Treasury bills and about 9% from I Bonds (although only for about $20,000 invested per couple). When the Treasury bills mature in December, you should be able to get 4%. I'd take this. It's not all or nothing, so you can do this with as little or as much of your holdings as you like.

If you're right, you earn interest every day while you sleep, and if stocks crash from here, you can buy blue chips about 20% lower and get a lot better compensation for the long-term issues with debt and demographics that we're going to be facing. If you're wrong, you make a safe return of 4% or so.

If you bought stocks pre-pandemic and you want to hold them, that's fine. If you bought them in 2021 or 2022, you're probably underwater, and I'd take the tax losses. Either wait 31 days to buy them back, buy similar/correlated stocks, or sit money in cash and earn as much as 4% by the end of the year with no risk. I don't like the risk-reward of the broad index here, although I will continue to publish on the prices I think you should snap up blue-chip stocks like Microsoft ( MSFT ) and Google ( GOOG ) ( GOOGL ) in the likely event that markets keep falling.

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