Stocks rise as inflation data continues to improve

If stock market experts were so expert, they would be buying stocks, not selling advice. – Norman Ralph Augustine

Better than expected inflation data was just what the stock market needed last week and the major averages responded with gains across the board. The S&P 500 Index climbed nearly 3% while the Nasdaq Composite Index jumped almost 5% as investors bought beaten-down technology stocks. It was the sixth straight day that the Nasdaq was higher as investors are becoming more optimistic that inflation has peaked and is gradually headed lower. The consumer price index (CPI) in December actually fell slightly during the month and was in line with estimates, registering the biggest drop since April 2020. The biggest reason for the decline was a drop in gasoline prices, although the year-over-year increase in the CPI is now 6.5%, still too high even though it is rapidly moderating. Shelter costs, which account for about 40% of the core consumer price index, were higher than forecast but should come down over the next few months. Last week also marked the beginning of the fourth quarter earnings season and was led by the four biggest money center banks in the country. JP Morgan Chase topped revenue and earnings expectations as interest income surged on higher interest rates and strong loan growth. However, the company set aside $2.3 billion as a provision for possible loan losses as it expects a recession to occur in the fourth quarter. Bank of America and Citigroup also reported better than expected results, although both companies increased their provision for loan losses as well. Only Wells Fargo reported lower than anticipated revenue and earnings as net income fell 50% from a year earlier as the company also announced it would retrench from the U.S. mortgage market. All in all, it was an encouraging week for the market as bond yields also fell as investors realized that cooling inflation data could mean a less aggressive Federal Reserve.  A classic Wall Street rule suggests that the market will end the year with a positive return if stocks post gains in the first five trading sessions. The S&P 500 has finished the year in positive territory 83% of the time with an average gain of 14% if this occurs and in 2023, the S&P 500 gained 1.1% over the first five trading days.

Last Week

Other than the consumer price index released last week, it was a quiet week for economic data. The National Federation of Independent Business’s Small Business Optimism Index fell in December from November as business owners face economic uncertainties and persistent high inflation. Weekly jobless claims were better than expected as they fell 1,000 to 205,000, compared to projections of an increase in claims of 6,000. The University of Michigan consumer sentiment index in January was higher than in December and the one-year inflation outlook was lower for the third straight month.

For the week, the Dow Jones Industrial Average rose 2% to close at 34,302 while the S&P 500 Index increased 2.7% to close at 3,999. The Nasdaq Composite Index surged 4.8% to close at 11,079.

This Week

The producer price index (PPI) for December is expected to increase nearly 7% year-over-year, but less than in November as inflation remains in a downtrend. Retail sales data for December is forecast to decline by the same amount as in November. December housing starts and existing home sales are both expected to be less than in November as the housing market continues to be weak.

The Federal Reserve releases its beige book, which summarizes current economic conditions across the 12 regional Fed districts, and the Bank of Japan (BOJ) announces its monetary policy decision, which could involve a hike in its benchmark interest rate to zero from negative 0.1%.

Among the most notable companies scheduled to report fourth quarter earnings this week are Goldman Sachs, Morgan Stanley, Charles Schwab, Discover Financial Services, PNC Financial, Fifth Third Bancorp, Key Corp., Northern Trust, State Street, Procter & Gamble, Netflix, J.B. Hunt, United Airlines, Kinder Morgan and Schlumberger.

Portfolio Strategy

Many investors allocate their portfolios using a balanced approach between equities and fixed income in order to get a mix of both growth and income. After last year when the performance of a portfolio with 60% equities and 40% bonds was dismal, such an allocation has been called into question as a viable option in the future. A portfolio that was invested with a 60% allocation in the S&P 500 Index and a 40% allocation in the Bloomberg U.S. Aggregate Bond Index would have lost 16% last year, which was the worst year for such an allocation since the Great Recession and the financial crisis in 2008. Bonds usually provide a ballast in a portfolio by providing stability and income, but the Federal Reserve raised interest rates seven times in 2023 from near zero to a range of between 4.25% and 4.50% to combat high inflation. These interest rate hikes caused bond prices to fall and pushed yields higher, resulting in a loss of 13% for the Bloomberg U.S. Aggregate Bond Index last year. (Bond prices and yields move in opposite directions). But with the 10-year Treasury currently yielding about 3.50% and the 2-year Treasury yielding about 4.20%, the odds of another double-digit loss in bonds are slim. It appears that inflation has peaked and is trending lower, which should allow the Fed to ease this rate hiking cycle and stop altogether when the federal funds rate hits about 5.10%. If this occurs, bonds should once again provide stability in a portfolio and allow investors to collect income without worrying that bond prices could continue to fall.