The S&P 500 (SP500) is down -8.4% from September 13 (-24.7% year-to-date), following a CPI print of August higher than expected which spooked the stock market and triggered a brutal sale. The next CPI in September the release of the data could potentially mark the bottom of the market, providing a great opportunity for investors with a bullish outlook on the S&P 500.
The broader market remains overwhelmed by fears that inflationary pressures could lead to even more aggressive monetary tightening by the Federal Reserve, increasing the risk of a deep and painful recession. We are just hours away from the September CPI data release, and the The Cleveland Fed’s latest inflation nowcast suggests that another S&P 500 selloff could be in the offing.
Cleveland Fed Inflation the nowcasting model uses real-time data to estimate core CPI as well as the Fed’s preferred inflation gauge, the Personal consumption expenditure (PCE) price index. By both measures, the nowcast data shows monthly inflation accelerating in October compared to the September reading.
Price included or not?
It’s hard to say how much of this bad news has already made it into the S&P 500. But trying to guess what the market thinks feels like a wild ride. Instead, investors are better off focusing on the general inflation trend rather than the noise of monthly CPI data. And worse, following the higher frequency and increasingly short-sighted nowcasting pattern we just shared.
Nevertheless, this myopia and fickleness of short-term traders pushes stock prices to extremes, and it actually benefits longer-term investors. And it is up to us to take advantage of this lack of behavior. When sentiment turns extremely bearish, prices are often pushed to levels that provide a rare opportunity to buy stocks at a steep discount.
The graph below shows that investor sentiment has rarely been so pessimistic in the past decade.
Another chart, dating back to the 1970s, also shows that consumers have rarely been so pessimistic about the economy. More importantly, whenever consumer sentiment bottoms out, subsequent 12-month returns for the S&P 500 have been exceptional (averaging 24.9% over the last 8 sentiment lows).
Inflation will tend to fall until we see another spike in commodity prices
From a more forward-looking perspective, the outlook for consumer price inflation looks quite good. We continue to see signs of moderating inflationary pressures across commodity prices as supply-side disruptions continue to dissipate.
The graph below shows the Bloomberg Commodity Index, which broadly reflects price movements in commodity futures markets. Since June, commodity prices, which affect input costs for producers of all kinds of consumer goods, have declined overall.
Despite the October 5 agreement between OPEC+ member countries to cut crude oil production by 2 billion barrels per day, we view the cut as a cartel move to keep prices stable within the target range. US$80-90/bbl. As long as crude oil prices do not rise above US$120 a barrel, we remain optimistic about the outlook for inflation.
Meanwhile, supply chain bottlenecks caused by lockdowns during the pandemic and exacerbated by inventory replenishment as the economy reopens, are also dissipating. The graph below shows the New York Fed Global Supply Chain Strain Index, which tracks transportation cost data and manufacturing surveys to assess global supply chain conditions. Once again, the index suggests that supply chain conditions have steadily improved over the past few months.
Consistent with the evidence we highlighted above, we expect CPI data to continue its downward trajectory towards the end of 2022 and into 2023.
In fact, prices don’t have to be in a sustained decline for the CPI data to show a downtrend. All it takes is for prices to remain stable for year-over-year CPI measures to tend to fall due to base effects. For a good detailed explanation of why inflation calculations may look worse when we only look at year-over-year data, see The mathematics of inflation can make matters worse.
As long as commodity prices continue to decline or hold steady while supply-side disruptions continue to dissipate, the next two CPI prints should reaffirm our view that inflation is largely stoked. by supply-side factors and will ultimately be transitory.
Technical image looks good
The S&P 500 technical chart is also starting to look convincing. Using a longer-term Fibonacci retracement stretching from the S&P 500 low in March 2020 to its all-time high in January 2022 shows strong technical support around the 3,500 level.
If the 3500 level holds, we see a potential rebound towards 3800. A successful and decisive break above this level would then suggest further upside towards 4200, possibly by the end of 2022.
We consider the current pessimism in the equity market and fears that persistent inflation will force the Fed to plunge the economy into a deep and painful recession to be largely unwarranted.
Instead, we view the recent SP500 selloff as an attractive opportunity for investors looking to enter the market. We see the SP500 gearing up for an energetic rally through the rest of 2022.