Stocks Still in a Sweet Spot
The S&P 500 was down for the second consecutive week last week, but even combined declines were modest at just -0.3%. A pause is normal and even healthy for a bull market. In addition, several signs continue to indicate an overall healthy market. Year-to-date gains are in the “Goldilocks” range — strong but not too strong — and the market is exhibiting solid participation across stocks, sectors, and regions.
- The S&P 500 saw modest declines for the second week in a row after a small inflation upside surprise.
- Nevertheless, solid year-to-date gains and broadening participation point to underlying market strength.
- We believe the inflation report was better than it appeared and the overall trajectory of inflation has not changed.
RETURNS ARE GOOD, BUT NOT TOO GOOD
The S&P 500 Index is up 7.3% year-to-date as of Friday. If that’s where we land at month-end, returns would be in the 75th percentile of all quarters since 1950 (higher is better). We ranked all quarters since 1950, divided them into five equal groups (best quarters, next best, etc.), and reviewed how the S&P 500 performed over the next three quarters. The second group, which is where returns are currently, has historically performed best over the next three quarters and posted a gain with the greatest frequency.
None of these groups has bad returns, but maybe lower your expectations if one quarter’s returns are toward the middle. It’s also worth highlighting the group we’re currently in has the lowest variability in returns, while the bottom group has the highest variability and the second-best performance. Low variability is a positive sign. And even if returns drift into the top group by the end of the quarter, they would be in the lower part, where expectations are better.
Here’s another perspective — viewing 10% of the data at a time based on rank, so similar quarters are grouped together. Low returns (x-axis) have resulted in better returns over the following three quarters (y-axis). Minimum future expected returns, historically, bottom at around a quarter with a 1% return, before improving. The two peaks on the right-hand side are at about 5.5% and 8.0%, but this is an average return of a grouping of quarters. So, consider this as about the center of 10% of available data. Then conditions tail off with stronger returns.
The 10 best and worst quarterly returns for the S&P 500 since 1950 are listed below, along with returns from the following three quarters. While this is a small sample, they generally hold true to form.
LET’S TALK ABOUT BREADTH
Increasingly, the market’s strength includes more than a small number of stocks. Energy and materials were the top performing sectors last week, and value did well. That’s not a forecast of things to come, but seeing rotation among leadership is a sign of a healthy market. Ten of 11 S&P 500 sectors are now up so far this year. Approximately 78% of S&P 500 stocks are above their 200-day moving averages. Even 75% of European countries are above their 200-day moving averages, according to Ned Davis Research. And the Magnificent 7? Some are still magnificent: NVIDIA, Meta, and Netflix are all among the top 20 S&P 500 stocks year-to-date, and Microsoft is beating the broad index. But Alphabet (Google’s parent company) is lagging the S&P 500, Apple is in the bottom 50, and Tesla is dead last, even trailing Boeing.
STILL CONFIDENT IN OUR STOCK OUTLOOK
At Carson, we do not believe investors should be concerned about the rest of the year’s market performance, simply because the first quarter has been so strong. If anything, performance over the first quarter should be encouraging, and plenty of signs suggest the rest of the year will play out well. However, we caution investors to expect a pause and possible near-term volatility.
Overall, we’re still confident about maintaining our Outlook 2024 estimate of stocks gaining between 11-13% this year.
Inflation Report Better Than It Looked
The latest consumer price index (CPI) inflation data for February, released last week, came in slightly ahead of expectations, which led the commentariat to worry about “sticky” inflation that doesn’t go away. However, we saw it differently after taking a closer look at the numbers.
Headline CPI inflation did rise 0.4% in February, which was higher than the 0.3% increase in January, mostly thanks to a 3.6% increase in gas prices. CPI inflation is currently up 3.2% since February 2023.
But here’s the big picture: Inflation has eased a lot since June 2022, when it hit 9%. It does appear to be stalling at just over 3%, but as the chart below shows, shelter (dark green bar) has been the largest driver of inflation. No other category is contributing as much as shelter, and despite the February increase, the contribution from energy prices is nothing compared to what we saw in 2022. The good news is that the contribution from food prices (bright red bar) has also shrunk significantly.
Shelter Inflation: Good News and Bad News
Last month we wrote about how shelter is keeping CPI inflation elevated. That’s still the case. Excluding shelter, headline inflation has run at a 1.8% annualized pace over the last six months, which is similar to its year-over-year increase.
A large component of shelter is “Owners Equivalent Rent” (OER). It is the implicit price at which homeowners are assumed to rent their homes to themselves. It’s derived from market rents of single-family homes and has nothing to do with home prices or mortgage rates. It makes up 27% of the CPI basket, which is ironic because a large majority of American households own their homes (66%) and do not experience anything like OER. Meanwhile, regular rents of primary residences make up 7% of the CPI basket. So, it’s clear how shelter can have an outsized impact on CPI inflation.
OER inflation unexpectedly surged in January to an annualized pace of 6.9%, the largest monthly increase in 10 months. There was some concern that this could be the start of an unwelcome uptrend in shelter inflation, driving overall inflation higher. But the January surge was likely a one-off, and the good news is February data reverted to what we saw in the fourth quarter. OER inflation rose at an annualized pace of just 5.4% in February. Regular rental inflation came in at 5.0% (annualized) — that’s slightly higher than in January but lower than in late 2023. The bad news is these readings are still elevated relative to where they were pre-pandemic (around 3-3.5%).
Looking ahead, rents and OER still appear to be following the path of private market data, albeit with a long lag. Encouragingly, private data is still showing rents falling on a year-over-year basis, which means we needn’t be too worried about a resurgence in rental inflation.
Really Good News: Food Price Inflation Is Easing
Easing food price inflation was underreported amidst all the negative headlines about CPI data. But food price inflation has been slowing, and that’s a big deal for three reasons.
First, easing food inflation is a big boost to household wallets. Food typically makes up a larger wallet share than energy, and recent data is very encouraging. Grocery store prices (“food at home”) were flat in February and are up just 1% over the last year. That’s down from a peak of 13.5%. Despite that, food services inflation, including fast food and full-service meals (“food away from home”), has been running strong recently. But we saw a big pullback in February, with prices rising just 0.1%. It’s still up 4.5% from last year, but that’s down from a peak of 8.8%.
Here’s a quote from Costco’s CFO during their earnings call, one that underlines what we’re seeing in the data:
“A couple of comments about inflation. In the last quarter, in the first quarter, we estimated that year-over-year inflation was approximately 0 to 1%.
We’ll now say that in Q2, it was essentially flat. And notwithstanding essentially flat, we’re taking price reductions where we can. Anecdotally, everything from simple items like reading glasses from $18.99 to $16.99, the 48 count of Kirkland signature batteries from $17.99 to $15.99, a 24-count of Pellegrino from $16.99 to $14.99 and even 4 pounds of frozen fruit plan for $14.99 down to $10.99 with new crop pricing. So we continue to do that.”
Second, easing food services inflation is positive for the Federal Reserve’s preferred inflation metric, personal consumption expenditures ex food and energy (“core PCE”). Interestingly, food services are not included in core CPI, but they make up 6% of core PCE and have driven excess inflation on that side. So, the pullback is good news for core PCE inflation.
Third, easing food services inflation suggests that underlying inflation pressure is easing. Specifically, within foods services, “full service meals (and snacks)” has historically tracked core inflation closely, as the chart below shows. That’s despite only a 3% weight in the core CPI basket (Matthew Klein at the Overshoot has pointed this out before). In fact, it tracks core CPI better than OER (despite OER’s huge weight in the basket).
Full-service restaurant meals combine several elements that go into inflation, including:
- Commodity prices: food and some energy prices (costs such as crop fertilizers and diesel for transportation)
- Wages for workers in restaurants
- Rents of the restaurant premises
All the above have eased considerably over the last year, and that may be starting to show up in the inflation data. CPI inflation for full-service meals rose just 0.1% in February, the slowest monthly pace since August 2020. It’s up 3.8% from last year, but that’s down from a peak of 9% in 2022 and not far above its pre-pandemic pace of 3.5%. This more than anything else suggests underlying inflation, aside from shelter, is running close to the Fed’s target of 2%.
Here’s the Big Picture
Inflation is still easing but with a few bumps along the way. CPI inflation was on the hotter side over the last two months, but there were positives within the February data. The downtrend from late last year is intact, and importantly core PCE inflation is likely to be softer than its CPI counterpart. Also, easing inflation for full-service restaurant meals lessens the likelihood of a resurgence of inflation. And it suggests underlying inflation is already at, or close to, the Fed’s target.
These points indicate we’re still on track to see interest rate cuts in 2024 but fewer than what the market expected at the beginning of the year. We’ve always believed the Fed is likely to cut rates by 0.75-1% in 2024, and we haven’t changed that view, assuming economic growth continues along trend. That’s still positive for markets, as the Fed looks likely to cut rates into a strong economy, one that is seeing higher income growth thanks to easing inflation. In our latest Facts vs Feelings episode, Ryan and I chatted about how sentiment is beginning to shift as skeptics acknowledge the more positive outlook.
This newsletter was written and produced by CWM, LLC. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The views stated in this letter are not necessarily the opinion of any other named entity and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.
S&P 500 – A capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The NASDAQ 100 Index is a stock index of the 100 largest companies by market capitalization traded on NASDAQ Stock Market. The NASDAQ 100 Index includes publicly-traded companies from most sectors in the global economy, the major exception being financial services.
A diversified portfolio does not assure a profit or protect against loss in a declining market.
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