Stocks soar on better-than-expected inflation data, S&P 500 up 5.9%

In investing, you get what you don’t pay for. Costs matter. So intelligent investors will use low-cost index funds to build a diversified portfolio of stocks and bonds, and they will stay the course. And they won’t be foolish to think that they can consistently outsmart the market. – John Bogle

The biggest rallies in the stock market occur during bear markets and that was no exception last week as the Nasdaq Composite Index surged over 8% and the broad-based S&P 500 Index jumped nearly 6%, closing just below 4,000. For the Nasdaq, it was the best weekly performance since March even though the news for some of its most influential companies was negative. Apple said that iPhone production has been temporarily reduced because of Covid-19 restrictions in China and Meta Platforms (Facebook) announced layoffs of 13% of its workforce. But it was the consumer price index (CPI) for October that was the most significant catalyst for the stunning rally in stocks. On Thursday, the CPI rose only 7.7% on an annual basis, less than expectations of an 8% increase and lower than in September. The core CPI, which excludes food and energy prices, was also less than expected. While the rally in the S&P 500 of 5.5% that day was probably an overreaction, the CPI data could signal that inflation has peaked, allowing the Federal Reserve to be less aggressive with interest rate hikes in the months ahead. The bond market seemed to agree as the yield on the 10-year Treasury fell to 3.8% while the yield on the 2-year Treasury dropped to 4.3%. The dollar also hit its lowest level since August, which benefits multi-national companies that generate profits in overseas markets. The other factor responsible for the strength in the stock market was the results of the mid-term elections. Although the much talked about red wave by the Republican party failed to materialize and the Democrats maintained control of the Senate, it appeared that the GOP would win control of the House of Representatives. Federal government gridlock following the mid-terms usually means better performance in the S&P 500 as it is associated with government inaction that will limit spending, new taxes and regulations.

Last Week

The University of Michigan consumer sentiment index in November fell to its lowest level since July as higher interest rates, a potential recession and elevated inflation made consumers less confident about the economy. One year inflation expectations also rose higher than expected. Weekly jobless claims were 225,000, higher than estimates of 220,000 and higher than the previous week’s total of 218,000.

For the week, the Dow Jones Industrial Average rose 4.2% to close at 33,747 while the S&P 500 Index climbed 5.9% to close at 3,992. The Nasdaq Composite Index surged 8.1% to close at 11,323.

This Week

The producer price index (PPI) for October is expected to increase 8.3% year-over-year, less than in September and much less than its record high set back in March, but still elevated. October retail sales are forecast to be higher than in September while the Leading Economic Index for October is expected to decline again as it has fallen most of the year. Both October housing starts and existing home sales are forecast to be less than in September as the housing market remains weak. The National Association of Home Builders (NAHB) Housing Market Index for November is also expected to be lower as higher mortgage rates have negatively affected their outlook.

Retailers will dominate the third quarter earnings reporting season this week and the most notable of these companies are Walmart, Target, Home Depot, Lowe’s, TJX Cos., Kohl’s, Macy’s, Ross Stores and the Gap. Other companies scheduled to report include Tyson Foods, Advance Auto Parts, Cisco Systems, Applied Materials, Palo Alto Networks and Nvidia.

Portfolio Strategy

Although it was confirmed over the weekend that the Democrats won control of the Senate with wins in Arizona and Nevada, the House of Representatives is still up for grabs with the most likely outcome being the Republicans winning a slight majority. If history is a guide, divided government is good for the markets provided the Republicans do, in fact, take control of the House. With the outcome still in doubt, the uncertainty could affect the markets in the near-term, causing increased volatility until the results are finalized. Whatever the outcome, though, the market has historically performed well after the mid-terms.  Since 1946, the stock market has been up 100% of the time in the 12 months following a mid-term election and up 6 months after a mid-term election every time since 1950. However, there is a unique set of circumstances this year that may break this trend. While the consumer price index (CPI) was less in October than in September, it is still much higher than the Federal Reserve’s target of 2%. For this reason, the Fed will probably still raise the federal funds interest rate by at least 50 basis points (a basis point is one hundredth of one percent) at its meeting in December. Also, with most economists forecasting a recession in 2023, earnings expectations for next year are probably too high and need to come down. Federal Reserve rate hikes have lagged effects on the economy, which could have implications for S&P 500 company valuations. The current price earnings ratio for the S&P 500 is about 16, slightly above the long-term average of 15. That is down considerably from the start of the year, but much higher bond yields could make future profits worth less, indicating that current equity valuations are too high. With so many crosscurrents and so much uncertainty facing the market, reducing the high rate of inflation may hold the key to how stocks perform the rest of this year and early next year.