Inflation… How Low Can It Go?

October’s CPI came in below expectations and fueled an explosive recovery on Wall Street with the S&P 500 (SPY) rising over 4% and bonds also shooting higher. In essence, the odds of a soft landing are increased if inflation can go down and then continue to go down. This development is also likely to cause the Fed to slow the pace of hikes. Of course, the next big question, assuming inflation has peaked, is how low will it drop? Will it stabilize at higher levels or go back to the 2% range? Today’s commentary will explore these questions and the implications for our portfolio. Read below to learn more…



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(Enjoy this updated version of my weekly commentary originally posted on Nov 11the2022 in the POWR Stocks Under $10 newsletter).

Over the past week, the S&P 500 (SPY) has risen 6.4%. After the FOMC, stocks were pretty choppy before roaring higher on the softer-than-expected CPI report.

It should be obvious to anyone why falling inflation is such a big deal, as it would basically mean that a big market headwind turns into a tailwind.

Falling inflation alone would provide relief to consumers and lead to margin expansion for businesses.

Furthermore, it would cause rates to fall, which would also boost the housing market and reduce borrowing costs for corporations.

In essence, it would reverse much of the market’s pain. And that was evident in today’s action, which saw leadership from both homebuilding stocks and speculative tech stocks, as both groups have been hit by rising rates.

So it makes sense that if rates are going to reverse and go lower, these are the groups that will outperform on the upside.

Inflation Path + Earnings

In hindsight, it appears that inflation peaked this summer. And it is possible that the stock market successfully spotted it when it bottomed out along with the high CPI reading.

These lows were then retested and undermined in October with a lower high for CPI but a higher high for core CPI, before bouncing back once more in the last two weeks.

Going into the CPI report, I had a mixed opinion on the number, but was leaning lower on the market due to a hawkish Fed and a slowing economy.

The inflation reading neutralizes the previous factor, at least in the short term. This is evident with the large decline in yields, and higher highs in inflation would be needed to get new highs in yields.

In fact, I’m sure we’ve seen the high cycle in returns.

This means that the bear case is based on seeing an earnings contraction triggering another leg lower in stock prices.

And longer term, the path inflation takes will determine Fed policy and whether we are in the late or middle stages of the bear market.

Portfolio Implications

We move to a neutral stance ahead of the FOMC. And ironically, we are back to those levels as of today’s close.

Even with a higher-than-average cash allocation, our portfolio grew more than 3% and we had numerous stocks that grew 5-9%. YTD, the portfolio is down 5% while the broader stock market (SPY) is down 15% with an even bigger draw for the Russell 2000.

As I said before, I think the CPI report is a game changer…in the short term. You should place a bid below the market, as it eliminates a downside risk: yields rise steadily as inflation spirals higher.

In the more intermediate term, if we assume that inflation continues to fall, then the focus will shift to earnings.

If earnings can stay flat or even continue to grow, I think the stock will continue to rise. If earnings start to show damage, then we could see share prices fall along with yields and inflation.

Portfolio-wise, I have avoided many tech and housing stocks due to the relentless rise in yields. This is no longer the case, and I think we can start looking for bargains among this group.

Summary

The FOMC meeting was bearish, because it meant the window for a “soft landing” had narrowed.

In my opinion, the latest CPI strengthens the bull case and could significantly strengthen the bull case if it turns out to be the start of a downward trend in inflation.

But, it is too early to say if this is the case. And we also have the dynamics of a slowing economy that is enough to send stocks lower even as inflation moves lower.

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My best wishes!

Jaimini Desai
Chief Growth Strategist, StockNews
Publisher, POWR Stocks Under $10 Newsletter


SPY shares closed at $398.51 on Friday, up $3.82 (+0.97%). Year-to-date, SPY is down -15.12%, versus a percentage increase in the benchmark S&P 500 index over the same period.


About the author: Jaimini Desai

Jaimini Desai has been a financial writer and reporter for nearly a decade. The goal of it is to help readers identify risks and opportunities in the markets. She is the chief growth strategist for StockNews.com and the editor of the POWR Growth and POWR Stocks Under $10 newsletters. She learns more about Jaimini’s background, along with links to her most recent articles.

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