Why Are Stocks Still Higher After A Week of Bad Inflation Numbers?

Assuming nothing drastic happens during today’s trading session, the major stock averages will finish this week higher for the third time in the last four weeks. It has been a week in which headline CPI, the most widely used measure of inflation, showed a month on month increase, coming in at 3.2% for February versus 3.1% for January, which was worse than expected. PPI, the measure of prices at the input level for companies and therefore often a leading indicator for retail inflation, was no better, either. That index climbed 0.6% for the month, double the expected 0.3%.

We have all been told for a while now that the market has hit record highs because traders and investors are pricing in expected interest rate cuts this year, but how can those expectations be maintained in the face of inflation that is more than fifty percent above the Fed’s stated 2% target?

Well, the most frequently heard reason for the market remaining strong in the face of what were concerning and bad inflation reports this week is that they are a blip, a one-off that is just noise. Again, that sounds reasonable at first, until context is applied.

The worse than expected and higher than desirable inflation numbers weren’t a one-off at all. The January numbers showed the same thing, stubborn inflation that has stalled at just over 3%. And yet February’s CPI and PPI were still worse. Objectively, the latest available data show quite clearly that for all the progress made against inflation, price hikes have plateaued at a rate much higher than the Fed would like.

If anything, that would suggest that the FOMC should maybe hike a quarter point or so over the next few months, certainly not cut.

And yet, the one-month chart for SPY, the S&P 500 index tracking ETF for the period since the disappointing January numbers were released a month ago looks like this:

One of two things is happening here, or some combination of both. Either the market is sticking its fingers in its ears and shouting “Nah, nah, nah” at the top of its voice in a conscious attempt to ignore evidence that contradicts its preconceptions, or the bull market has been about something other than rate cuts. It is probably a bit of both.

Having spent decades in dealing rooms and an equal amount of time working with individual traders one way or another, I am all too aware that traders are not immune to human weaknesses. That can even be true of algorithmic traders, which are, after all, programmed by people. People are subject to things like confirmation bias and a natural inclination to ignore bad news. There are a lot of people who have bet a lot of money on the Fed cutting rates soon, and they seem to be cherry picking news, celebrating anything that makes that look smart while ignoring or downplaying anything that does otherwise.  

The current conventional wisdom is that the Fed will start to cut rates in June. That is interesting in itself given that, just a couple of months ago, a March cut was being assumed by many. Even as it has become clear that is very unlikely to happen, though, the buying pattern has been maintained. It seems that traders are people after all, and admitting that they were wrong is proving hard, especially when everyone feels the same way.

Still, that doesn’t completely explain why stocks are still at or near their highs after two months of evidence that inflation is proving far stickier than most people had assumed it would be. One of the first things I was taught when I started in the market was to constantly check for my own biases and emotions, and over the years I came to see that those who were unable or unwilling to do that in an honest way rarely lasted very long. I am sure that is still true and still taught, so it is reasonable to assume that a good number of traders have performed that self-check but saw no reason to reverse positions.

They must have had a reason for that, and the most likely is that the longer the U.S. economy has lived with a 5%+ Fed Funds Rate, the more it looks like it can handle it. The economy is still growing, albeit at a steady rather than spectacular pace, the jobs market is holding up with unemployment hovering around all-time lows and, most importantly for stocks, corporate profits are holding up pretty well. A rate cut at some point would help on all those fronts, of course, but if circumstances dictate that one doesn’t come for a few months, so be it.

That suggests that if the market mood is to change, it will take more than a couple of months of disappointing price data. Until the economy shows signs of finding 5.25% interest rates a real burden, traders might slow down the buying a bit, but they are unlikely to start selling in a big way.

There have been some hints that the initial strength that carried the economy through the rate hikes is fading but, so far, it is not fading far enough or fast enough to make anyone believe that real trouble is imminent. At some point, if 5% interest rates do take their toll. stocks will drop, but as long as there is no drastic change in economic conditions, traders can keep their fingers in their ears and the market can keep moving higher.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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