Stocks surge on better than expected July inflation data

It is only in a bear market that the value investing discipline becomes especially important because value investing, virtually alone among strategies, gives you exposure to the upside with limited downside risk. – Seth Klarman 

The major stock averages all rallied last week as investors cheered better than expected news on the inflation data in July. The broad-based S&P 500 Index surged over 3% for its fourth straight weekly gain after the consumer price index (CPI) for that month was flat and rose 8.5% from a year ago, which was less than anticipated due mainly to falling energy prices. The core CPI, which excludes food and energy prices, was also less than forecast on a monthly basis and year-over-year, suggesting that inflation may have peaked and could be headed lower in the coming months. While this is certainly welcome news for investors, it may be premature to celebrate victory as an annual inflation rate of 8.5% is still well above the Federal Reserve’s target of just 2%. The Fed is committed to bringing down inflation and will likely remain aggressive in its monetary policy tightening by continuing to raise interest rates. The favorable CPI number may prompt the Fed to hike the federal funds rate by only 50 basis points (a basis point is one hundredth of one percent) in September instead of 75, but rest assured that more rate hikes will follow. While the inflation data was encouraging, the Fed still has a long way to go in its fight to control inflation, which is likely to remain stubbornly high.  On the quarterly earnings front, roughly 90% of companies in the S&P 500 Index have reported second quarter earnings and the results have been mostly better than expected. On average, companies in the index have beaten estimates by about 5%. But expectations had become very low heading into earnings season, so it was easier for companies to surpass these downwardly revised estimates. The strong rebound in stock prices has narrowed the year-to-date loss in the S&P 500 Index to only about 10% as it has recouped more than 50% of its losses since its low in mid-June. But the S&P 500 now trades at 18 times estimated earnings and with stock prices now more expensive, the market is likely to take a breather and trade sideways as future gains will be harder to come by.

Last Week

In addition to better news on consumer prices, wholesale prices in July also showed improvement. The producer price index (PPI) actually fell 0.5% in the month and the year-over-year increase was also less than forecast, although still high at nearly 10%. Import prices in July also fell more than expected. Weekly jobless claims totaled 262,000, an increase of 14,000 from the previous week but slightly below estimates. The University of Michigan preliminary consumer sentiment index in August came in at 55, topping expectations of 52.

For the week, the Dow Jones Industrial Average rose 2.9% to close at 33,761 while the S&P 500 Index surged 3.3% to close at 4,280. The Nasdaq Composite Index jumped 3.1% to close at 13,047.

This Week

Leading economic indicators in July are expected to decline for the fourth consecutive month as growth in the economy is likely to slow further over the near term. Retail sales in July are forecast to drop slightly after a strong 1% increase in June as consumer spending has remained fairly strong in the face of high inflation. Both July housing starts and existing home sales are forecast to be less than in the previous month as high mortgage rates and high home prices have reduced affordability.

The Federal Open Market Committee (FOMC) releases minutes from its July monetary policy meeting when it raised the federal funds rate by 75 basis points to a range of between 2.25% and 2.50%.

The most notable companies scheduled to report second quarter earnings this week are Target, Walmart, Home Depot, Lowe’s, Kohl’s, TJX Cos., Foot Locker, Agilent Technologies, Analog Devices, Cisco Systems, Applied Materials and Deere.

Portfolio Strategy

News on Friday that import prices in July had declined for the first time this year capped what could be called a pivotal week for inflation data as both wholesale and consumer prices also showed signs of easing. The producer price index (PPI) in July fell 0.5% while the consumer price index (CPI) was flat as energy prices dropped sharply during the month. While the lower-than-expected inflation readings are cause for optimism, it is still way too early to declare victory against high inflation. Despite the drop in import prices, the year-over-year increase is still nearly 9% while the consumer price index is up 8.5% from a year ago and the producer price index is up almost 10%. Even though the inflation data suggest that the worst of the price pressures may be over, the reports represent just one month’s worth of data. The most recent employment report in July also showed that 528,000 new jobs were created, nearly double the estimate from economists, suggesting that the economy remains strong. There will be another round of inflation and jobs data before the next Federal Reserve meeting on September 20^th and 21^st and the Fed has indicated it will remain data dependent in making its decisions on raising interest rates. Despite the improvement in inflation in July, the Fed is still a long way from its 2% target, which is why another 75-basis point hike in the federal funds rate is likely at their next meeting. At the same time, continued rate hikes could tip the economy into a recession, which an inverted yield curve is flashing right now with the 2-year Treasury yield of 3.25% exceeding the 10-year Treasury yield of 2.85% by 40 basis points.