CPI Hits 7.5% – What It Means to Us…

  • Headline CPI for January surprised on the upside registering 7.5% vs. expectations of 7.3%. What makes it more of a surprise is that the day before, the ‘whisper number’ was that CPI would come in below expectations.
  • The cause of the higher number is a scheduled change in weighting CPI categories that occurred in January 2022. From a broad perspective, the change in weights increased the weight on goods and decreased the weight on services. Without doing the math, it is clear that we would have been very close to consensus without the re-weighting, but markets are reacting violently anyway.
  • The market reaction is the obvious one, interest rates up and stocks down. However, the yield curve continues to flatten. (i.e., rates are up more in the belly of the curve than in the longer duration bonds). We are now at levels where the recession ‘yellow flag’ has been raised by the bond market.
  • The longer-term reaction is more important. What the re-weighting is likely to do is cause reported inflation to run hotter in the near term, but run cooler later in the year as the service economy picks up and the demand for goods heads back toward normal (easing supply chain pressures).
    • One thing to watch out for as this happens is for order cancellations…shortages cause buyers to double, or even triple, orders as a means to assure themselves of receiving what they actually need. When supply pressures ease, these orders get cancelled. That can slam the brakes on the ‘goods’ economy very quickly. We believe this possibility is currently being ignored.
  • In our humble opinion, the right move is for the Fed to remain patient, despite the comments of the ‘experts’. Any sudden aggressive move by the Fed is likely cause more consternation in markets as it would imply that they don’t know any more than the rest of us. If they misjudge and act too fast and/or too aggressively, a policy mistake (read: recession), becomes a probability, rather than a possibility.
  • Keep an eye on energy prices. Crude oil prices are up almost 50% over the last year. It’s hard to imagine that happens again in 2022, but a Russian invasion of Ukraine can change that dynamic very quickly. If fossil fuel prices continue to rise unabated, the pressure is on the Fed to hit the economic brakes harder. Energy costs have very large carryover impacts in other sectors. For example, one reason why food prices are so high is the high cost of fertilizer, which is driven by the cost of fossil fuels.

…And What it Means to Markets

Interest rates matter to the value of financial assets. In your first finance course, you typically learn one core fact. The value of any financial asset is the discounted value of the future cash flows from that asset. Higher interest rates = higher discount rates and that mean that higher rates imply lower valuations. But don’t worry about the math…a picture will do better.

Each dot on the chart below shows the trailing P/E ratio of the S&P 500 index AND the year-over-year change in the Consumer Price Index (CPI) at a given point in time. (The data below is monthly from 1965.) The blue dotted line is an exponential trendline (similar to a linear regression, but curved to follow the data trend).

 

What the chart shows is the relationship between the rate of inflation and stock market valuations. Why might this be important? Because inflation is often an important driver of interest rates (as they are right now). There is a very clear relationship which implies that when inflation is high, stock valuations are low. What we have today (the red dot) is a stock market that remains highly valued relative to the level of inflation.

According to the trendline, which is mathematically the line that best fits the data, an inflation rate of 7% is associated with much lower P/E multiples than we have today. To be fair, we don’t believe that 7% inflation will persist. As we discussed last week, even if inflation is 0.4% month to month, the annual inflation rate will naturally start to rollover in the Spring. So, let’s take a giant leap and assume that inflation at year end will be running at a 4% clip. Even then, the stock market, at about 22X trailing earnings remains very overvalued when compared with the 17x to 18x earnings implied by the trendline.

The bottom line is that we have had a substantial correction, but we believe that the odds favor a further correction in the stock market at some point this year and quite possibly sooner rather than later. In order to justify the current market valuation, it would require inflation returning to the 2% level and that is very unlikely to return anytime soon. We continue to believe a defensive posture is warranted. Rather than ‘buy the dip’, we’d prefer to ‘sell the rip’.

 

 

 

Disclosures:
Palumbo Wealth Management (PWM) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where PWM and its representatives are properly licensed or exempt from licensure. For additional information, please visit our website at www.palumbowm.com
Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this newsletter, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio.
The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.
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