Inflation has U-turned north … the risk of inflation derailing the bullish daisy chain … consider trading today’s market … the danger in comparison
Many investors were too busy with Thanksgiving preparation to notice, but last Wednesday, we received an important inflation report that should be on your radar.
Some in the financial media put a positive spin on it. For example, CNBC covered it with this headline, “Fed’s preferred inflation gauge rises 2.3% annually, meeting expectations.” While that’s true, there’s more to the story.
Stepping back, I’m referencing October’s Personal Consumption Expenditures (PCE) price index. And as a quick refresh, month-to-month PCE rose 0.2% and the year-over-year figure climbed 2.3%. As the CNBC headline suggested, these numbers matched consensus forecasts.
So, what’s the issue? After all, 2.3% inflation isn’t too far north of the Fed’s stated goal of 2% inflation.
Well, headline PCE is well below its high in 2022, and that’s certainly a good thing. But let’s fill in a few details…
The Fed cares more about “core” PCE than the headline number
This core reading strips out volatile food and energy prices.
The monthly and yearly readings for core PCE came in at 0.3% and 2.8%, respectively. So, October’s 2.8% reading means that inflation remains 40% above the Fed’s goal.
Now, you might brush this off based on where core PCE stood at its high in 2022 (5.6%), concluding “We’ve come a long way. This is still a great reading.” But even if so, we have a second issue – direction.
As you can see below, core PCE is U-turning north.
Source: Trading Economics
Some might say that the curve is just barely lipping upwards. This is nothing to be concerned about. But that depends on what you find concerning.
While the slope of the core PCE readings above might not represent a dramatic resurgence of inflation, it’s certainly not evidence of, to quote Jerome Powell, “a sustainable path back to 2 percent.”
Here are the month-to-month readings for core PCE over the last six months.
May: 0.1%
June: 0.2%
July: 0.2%
August: 0.2%
September: 0.3%.
October: 0.3%.
Where is the sustained downward progress?
This matters because our stock market is priced for a happy ending outcome
Today’s record-high prices don’t include any significant room for error. The prevailing bullish narrative can be summarized this way…
Inflation is vanquished… so, the Fed will cut rates many times in 2025… which will bring much-needed relief to financially exhausted consumers… which will bolster corporate earnings… which will relieve nosebleed valuations that are currently in bubble territory… which will keep the stock market party going.
But if inflation isn’t vanquished, this happy ending doesn’t materialize (or at least, not to the same degree). That would leave us with a stock market that looks very expensive relative to earnings.
To illustrate this, let’s start by looking at the forward price-to-earnings (PE) ratio. This shows what investors are paying today for what they believe will be earnings a year from now.
According to data provider FactSet, today’s forward PE ratio is 22.0. Now, this level is already high all by itself. FactSet reports that the 5-year average reading is 19.6 and the 10-year average is 18.1. And keep in mind that this is based on expected earnings which represents optimistic earnings forecasts from excited analysts (if they were less excited, this metric would be even more expensive).
Now, there is a valid case for this earnings excitement.
Here in the Digest, we’ve profiled how Trump tax cuts and deregulation could cause an explosion in productivity that gooses earnings. But if growth and earnings don’t materialize, what we’re left with is a price for the S&P that’s leaning way out over its skis.
For a sense of just how far out over its skis, let’s shift from the forward PE ratio to the Shiller PE ratio. This looks at what investors are paying relative to the average of the last 10 years’ worth of earnings. This smooths out short-term earnings fluctuations from different business cycles. We’re basically changing our analysis from “what we hope will happen,” to “what has already and is happening right now.”
As you can see below, today’s Shiller PE ratio is basically tied for the second-highest valuation ever.
Source: Multpl.com
So, why does the tiny little upswing in core PCE inflation matter?
Because it jeopardizes the “priced for perfection” sequence of dominos that investors have already priced into the market.
The bear case from Luke Lango
Our hypergrowth expert Luke Lango detailed the risk in one of his recent Daily Notes in Innovation Investor:
Let’s say inflation pushes back above 3% and moves towards 4%.
In that scenario, the Fed would stop cutting interest rates. They may even hike interest rates again.
That means, in this hypothetical scenario, the 10-year Treasury yield could spike to 5% or more. The S&P 500 is trading at 23.5X forward earnings – among its richest valuations in history.
Those valuation multiples on stocks will not be supported if the 10-year Treasury yield keeps spiking – meaning that, if we do get serious reinflation and yields spike, stock multiples will have to significantly drop.
To be clear, Luke doesn’t believe this will happen, and it’s not his base case. But the most prepared investor is usually the most successful. So, as Luke is doing, it’s important that we look directly at this potential risk and plan accordingly.
So, what do we do?
Regular Digest readers likely know what’s coming.
This is the point at which we recommend you identify your conviction level for each stock in your portfolio… establish clear trailing-stop levels for all holdings you don’t own with ironclad conviction… mind your position sizes… but then remain with this bullish momentum until things change…
While we stand by all that, let’s add two additional suggestions today…
First, consider trading today’s market rather than adding to your buy-and-hold positions (unless those positions trade at attractive valuations). After all, the valuation of the average stock today doesn’t scream, “buy me for the long haul!” Trading can be an effective way to benefit from this bullish momentum while reducing the potential drawdown that might be lurking out ahead with a buy-and-hold approach.
With this in mind, I’d like to introduce you to one of the most recent additions to our corporate family, Jeff Clark. Jeff is a 40-year market veteran who trades the markets regardless of direction – up, down, or sideways.
Since Jeff’s team began tracking his trade results in 2005, he’s provided his subscribers with the opportunity to make triple-digit gains over 50 times and double-digit gains more than 160 times.
To give you a better sense of Jeff and his trading approach, he recently sat down with our Editor-in-Chief Luis Hernandez for a short interview. You can watch it right here.
They discuss Jeff’s philosophy… the specific pattern Jeff looks to drive his market moves (he calls it a “magic pattern”) … and how limiting risk is an enormous part of his trading approach. Again, that interview is right here.
By the way, just this morning, Jeff came out with a new position in his newsletter, Jeff Clark Trader. I’ll let him give you the overview:
It’s a bad time to buy the banks.
Indeed, the entire financial sector looks vulnerable to a decline. So, it’s probably a good time to add short exposure to the sector.
It’s also worth noting that the bullish percent index for the financial sector (BPFINA) has been generating sell signals for the past few months. While none of the signals have led to a big decline yet, it is just a matter of time.
Jeff’s new trade is a bet that banking is about to slide. For more of his analysis as a subscriber, click here to learn more about joining him.
Our second suggestion steps into the psychological side of investing…
Check your motivation.
Is your attention focused on your specific investment goals (and its related timeline)? Or is your focus drifting as parts of this market begin to melt up?
A market like the one we’re in can be both fantastic and challenging – “fantastic” when our stocks are climbing… “challenging” when they’re not climbing as fast as other parts of the market that are in the headlines.
Such FOMO-based comparison increases the odds of emotion-based market moves…which usually doesn’t end well.
Warren Buffett had some blunt words about this years ago when interviewed on Charlie Rose:
You can’t stand to see your neighbor getting rich. You know you’re smarter than he is, but he’s doing all these [crazy] things and getting rich … so pretty soon you start doing it….
People don’t get smarter about things that get as basic as greed.
Buffett’s late business partner, Charlie Munger, took it one step farther:
The world is not driven by greed. It’s driven by envy.
Bottom line: We’re in a bull market, so yes, we absolutely want to take advantage.
But remember today’s valuation… remember the rosy assumptions underpinning bullish forecasts… and make sure you know how you’ll handle it whether this bull lasts another two years or two days.
Have a good evening,
Jeff Remsburg