S&P 500 drops on hotter than expected inflation data

Above all else, in other words, the stock market is people. It is people trying to read the future. And it is this intensely human quality that makes the stock market so dramatic an arena, in which men and women pit their conflicting judgements, their hopes and fears, strengths and weaknesses, greeds and ideals. – Bernard Baruch, was an American financier and statesman

Roller coaster rides are supposed to be fun but the one exhibited by the stock market last week was probably more terrifying for investors than fun. After the ride stopped on Friday, only the Dow Jones Industrial Average managed to eke out a gain for the week while the S&P 500 Index dropped about 1.5% and the Nasdaq Composite Index tumbled over 3%, its lowest close since July 2020. The scariest part of the ride occurred on Thursday when the consumer price index (CPI) for September increased more than expected and was up a startling 8.2% from a year ago, the biggest increase since August 1982. Core consumer prices that exclude food and energy also jumped more than forecast and almost assured that the Federal Reserve will hike interest rates by another 75 basis points (a basis point is one hundredth of one percent) at their meeting in November. As one might expect, stocks plunged at the opening after release of this inflation data, falling as much as 2.5% at session lows with the Dow down over 500 points. But, remarkably, the stock market staged a dramatic turnaround and ended the day with a gain of over 800 points or 2.8%. While the selling resumed on Friday and stocks posted modest losses, the extreme volatility that occurred the day before could be a sign that the market is closer to the lows than the highs and patience could be rewarded as stocks remain very oversold. Last week was also the start of the third quarter earnings season and, for the most part, the results were favorable. The big money center banks dominated the agenda and JP Morgan Chase and Wells Fargo both topped revenue and earnings estimates as rising interest rates helped them generate more interest income. PepsiCo, UnitedHealth Group and Walgreens Boots Alliance also reported better than expected results and gave investors hope that third quarter earnings might not be as bad as feared. The burden of proof will definitely be on corporations this earnings season as they still face daunting headwinds in the form of a weakening economy and the Federal Reserve tightening cycle, not to mention the ongoing war in Ukraine and China’s slowing economy.

Last Week

The producer price index (PPI) for September was also hotter than expected, but import prices fell more than forecast due to the strong U.S. dollar. Retail sales in September were flat and have risen over 8% for the year. Weekly jobless claims were 228,000, an increase of 9,000 from the prior week and higher than estimates of 225,000. The University of Michigan consumer sentiment index in October was slightly higher than in September, but inflation expectations also rose more than expected as prices moved sharply higher, and the Fed implemented higher rates to slow the economy.

The minutes from the most recent Federal Reserve meeting showed that Fed officials were surprised at the pace of inflation and expected higher interest rates to remain in place until prices come down. With the current federal funds rate now at between 3.00% and 3.25%, the market expects another 75-basis point hike at the next meeting, but Fed officials admitted that the pace of rate hikes will decelerate at some point.

For the week, the Dow Jones Industrial Average rose 1.2% to close at 29,634 while the S&P 500 Index declined 1.6% to close at 3,583. The Nasdaq Composite Index dropped 3.1% to close at 10,321.

This Week

Both September housing starts and existing home sales are forecast to be less than in August and industrial production is expected to be flat. The Leading Economic Index for September is expected to decline modestly after a similar decline in August. The Federal Reserve releases its Beige Book on the current economic conditions across its 12 districts.

The most notable companies scheduled to report third quarter earnings this week include Bank of America, Goldman Sachs, Northern Trust, Travelers, American Express, Charles Schwab, Netflix, Tesla, IBM, Johnson & Johnson, Abbott Labs, Lockheed Martin, Alcoa, Whirlpool, Dow, Union Pacific, CSX, Procter & Gamble, Baker Hughes, Schlumberger, AT&T and Verizon.

Portfolio Strategy

While the inflation data last week was hotter than expected and disappointing for consumers and investors alike, there are signs that inflation should move lower in the months ahead. The Federal Reserve has maintained that it is data dependent and wants clear evidence that inflation is coming down before ending its monetary tightening cycle. There are indications in the economy now that inflation will begin to fall. First, supply chain issues have mostly been resolved and prices for both inputs and outputs have declined sharply in the past few months. Second, consumer spending has not been as strong as evidenced by recent retail sales data and consumers have spent their stimulus money and there are no government plans to issue any more. Third, the sharp increase in mortgage rates should serve to put a damper on demand for housing and bring home prices down gradually. Finally, the jobs market has begun to weaken as only 263,000 new jobs were created in September, the smallest increase since April 2021, and there was a decline of over 1 million job openings in August.  What the Federal Reserve needs to recognize is that there is a lag between raising interest rates and achieving their desired effect on the economy. In the past, the Fed has made the mistake of waiting too long to get a desired outcome and then doing too much to correct it, compounding the problem. At this point in the cycle, the best possible outcome may be a shallow recession of short duration that slows economic growth, reduces inflation and begins to lower interest rates again.