Understanding the Market's Confusing Reaction to CPI Data
Hands up if you found yesterday’s price action in the stock market confusing. We were told in the run-up to the release of Consumer Price Index (CPI) data that a print that showed more inflationary pressure than expected could easily trigger a wave of selling, and for the first five minutes or so that is what we saw, as you can see from the chart below for the S&P 500 futures contract, ES.
What you can also see is that the expected selling did last only around five minutes, and then quickly reversed and we ended yesterday around thirty-five points higher than Tuesday’s close. If the reason for the recent panic in stocks was the fear of inflationary pressure as was frequently stated, and the data confirmed that that pressure exists, then the rapid bounce makes no sense.
From the other perspective, if the numbers were not as bad as feared and were already baked into prices, then the immediate drop makes no sense, so what can we make of it and, more importantly, learn from it?
In order to explain the initial drop, you must first understand that in the modern market almost all the trading done in the immediate aftermath of data releases is done by computers, not people. They are programmed with algorithms designed to react instantaneously to certain key words, phrases or numbers in the release.
Thus, when yesterday’s overall CPI data showed a 0.5% month on month increase versus the roughly 0.3% expected with core inflation (not including the volatile food and energy sectors) rose 0.3% rather than the 0.2% consensus estimate, the computers reacted as they were programmed to do, they sold:
The ensuing bounce was connected to a basic truth about markets and data that I have mentioned many times before. What matters when data are released is not the numbers themselves, but how they relate to expectations, and not just the published estimates of economists and analysts. There is another level of expectations among traders and large institutional investors that is about what is expected as compared to those expectations. In this case, after all the panic of the last couple of weeks, the big money was expecting, or rather fearing, a significantly higher number for core inflation than was estimated.
The headline 0.5% number fit that bill, but the 0.3% rise in core inflation, the number that the Fed uses in its assessment of upward pressure on prices, was not that bad. It left core CPI, on an annual basis, at 1.8%. That is higher than the 1.7% forecast, but still well below the Fed’s target rate of 2%. In other words, the longer-term message from these data is that inflation is still relatively low and that does nothing to change the Fed’s projected path of rate hikes.
That conclusion, however, takes analysis of the underlying numbers and trends and involves nuance. Computer trading programs are not designed to incorporate either of those things, so when the numbers came out, ES immediately dropped around fifty points. Nuanced analysis also takes a few minutes, so it was only after that initial rush that the more considered opinions and strategies of people rather than algorithms became clear, and at that point the market turned.
The thing is, as I have been saying all along, the last two weeks of volatility was based on an at best questionable premise not fundamental data and was therefore a buying opportunity. The assumption was that the Fed, who have been patient to this point and laid out a clear path of rate increases, would be panicked by recent moves in the Treasury market or inflation that is still below their target rate into changing course, and that interest rates getting closer to normal levels would cause an economic downturn.
That was unlikely under Chair Yellen, and cynical people would say that it is even less likely under the guidance of a political appointee of the current President.
So, what can we learn? Computer trading increases, maybe even creates, short-term volatility. It stands to reason, therefore, that investors, even those that trade actively in their accounts, should be wary of paying too much attention to such moves. Decisions should be made based on the performance of and prospects for individual companies, and a fundamental view of the economy.
After all the hype the initial move was scary but understanding that it was in many ways inevitable would have helped investors to avoid reacting, and to benefit from the over two percent jump since yesterday’s open.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.