What’s up with the neck-breaking roller coaster in stocks?
Last Tuesday, stocks broke a month-long bearish streak and launched into a rebound. Over a week, the S&P 500 soared 5.1%, the tech-heavy Nasdaq jumped 6.3%, and the Dow was up 3.9%.
But then, this Tuesday, the stock market carriage tilted at a 90-degree angle and hurtled downhill again—wiping out $1.5 trillion in a single day.
What’s sending stocks through these steep slopes? Short answer: Inflation, or expectations around it.
One indication is that the relief rally perfectly coincided with the lead up to August’s CPI release, which came out this past Tuesday. And before it, economists were dead convinced inflation would slow, if for no other reason than falling gas prices.
But it wasn’t just the August CPI. Over the past few weeks, there were a few seismic macro developments giving hope that the worst inflationary fears for the winter may not materialize, or materialize to a lesser extent than feared.
For starters, the West’s military support for Ukraine is starting to bear fruit.
In the past week, Ukrainian forces have mounted a history book-worthy counteroffensive, freeing 2400 sq. miles of land, reclaiming control over Kharkiv, its second-largest city, and pushing Russian troops past the war’s principal frontline. Ukraine’s advances offer hope that Russia will be pushed into some kind of resolution.
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For their part, Europe’s major economies have signed off on an unprecedented $375 billion in fiscal spending to freeze energy prices.
Germany unveiled a $65 billion package ($315 billion in US economy terms) and the UK pledged to spend a mind-boggling $150 billion in the next 18 months (equivalent of $1 trillion in the US economy). A fiscal spending approach to this energy crisis is good news for stocks because it won’t be consumers or businesses who bear most of the cost of exploding energy prices, it will be governments.
Of course, these billions of euros aren’t a free lunch. They are a huge addition to deficits and come hot on the heels of Covid spending, which raises the question of unsustainable federal debt. But hey, that’s a problem for another day.
That said, the August CPI came out on Tuesday and drowned out all this positive news. Contrary to the projected fall, inflation, in fact, rose 0.1% month over month despite a drop in gas prices. And we are back at it again.
Still hard to tell where the stock market will steer for the end of the year.
On one hand, you’ve got extremely bearish sentiment and defensive positioning. For example, one of the most followed sentiment indicators, BofA’s Bull and Bear Index, is at absolute zero (that is, you can’t get lower than that).
The paranoia is evident in massive outflows from stocks. In the week of Sep 7, investors pulled $10.8 billion from US stocks, according to BofA data. That’s the biggest exodus in 12 weeks.
Not only that, stocks haven’t seen any flows (net) over the past half year.
Such a defensive positioning is one of the key contrarian signals BofA and JPmorgan strategists are banking on. As BofA wittily titled its July Global Fund Manager Survey, “I’m so bearish, I’m bullish.”
On the other hand, with the Ukraine war still not resolved and the cold season kicking in, there’s a real risk the historic energy crunch will spark a devastating recession in Europe, which will spill over globally.
In that scenario, brace for an onslaught of downward earnings revisions and a fat “I told you so” from Morgan Stanley’s MS bears.
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