If we pull back 5% and then shoot 10% higher, taking out critical technical levels by mid-September, then a new bull market will be confirmed.

If we pull back 5% and then keep dropping (10%, 15%, etc.), then this will go down as the greatest bear market rally of all time.

We are crossing our fingers for a mild pullback followed by a much stronger bullish surge. But today, let’s look at the other possibility.

After all, wise investors focus more on what can go wrong than what can go right. It’s the old idea of “play great defense, and the offense will take care of itself.”

Recapping the bullish case

Just about everything hinges on inflation, and as an extension, monetary policy from the Federal Reserve.

If inflation is largely conquered, things fall into place:

Earnings won’t be as negatively affected by inflationary erosion… employers won’t have to batten down the hatches and lay off workers… the U.S. consumer will have more disposable income in his/her pocketbook to support the economy… and the Fed won’t need to keep the pedal to the metal on rate hikes.

Now, in good news, July’s Consumer Price Index (CPI) number was down from June’s. Even better, it came in below forecasts.

On top of that, gasoline prices, which make up nearly 5% of the CPI, continue to fall dramatically.

According to GasBuddy, the average retail price of a regular gallon of gas is about $3.85. It hasn’t been this low since the beginning of March.

Plus, we’re finishing a Q2 earnings season that hasn’t been as dire as feared. Yes, businesses are feeling inflation. But we haven’t seen the across-the-board earnings-cuts that many expected. And as corporate managers looked toward the end of the year, there haven’t been cries of “the sky is falling.”

We could also point toward any number of smaller pieces of bullish evidence.

For example, last week, the Business Outlook Survey from the Philadelphia Fed unexpectedly rose to 6.2 in August from negative 12.3 in July. Economists had expected the number to come in at negative 5.0.

There’s more we could highlight, but for the sake of brevity, here’s the takeaway: At this moment, the economy is not crumbling under the weight of inflation. And as importantly, inflation’s direction appears to have turned south.

Tying in stocks, regular Digest readers know that the stock market is forward-looking in nature. Given this, if Wall Street believes that economic conditions 12 months from today will be good based on the positive factors we just touched on, then that’s what it will price into the stock market.

Translation – we’re in a healthy pullback today, which will be followed by a rally.

But are economic conditions going to be so rosy in 12 months?

How the bull case might be overconfident

Have we tamed inflation?

I can’t say “no.” But anyone who says “yes” with certainty is either intentionally misleading you or uninformed.

I write that because if we dig into the most recent CPI report, we find that two of the three largest components of inflation rose last month.

From the Bureau of Labor Statistics:

The gasoline index fell 7.7 percent in July and offset increases in the food and shelter indexes, resulting in the all items index being unchanged over the month.

The energy index fell 4.6 percent over the month as the indexes for gasoline and natural gas declined, but the index for electricity increased.

The food index continued to rise, increasing 1.1 percent over the month as the food at home index rose 1.3 percent…

The shelter index continued to rise but did post a smaller increase than the prior month, increasing 0.5 percent in July compared to 0.6 percent in June.

Frankly, nearly all of the CPI victory can be attributed to lower gas prices. But as we pointed out last week in the Digest, crude oil prices could easily race higher from here.

Goldman Sach’s head of energy research sees retail gasoline prices in the U.S. surging back to about $5 per gallon, with Brent oil futures going as high as $130 per barrel.

But the skeptical investor might say, “come on, Jeff, how likely is it that inflation will reverse direction and begin climbing again after peaking?”

Well, it’s not unlikely.

Richard Curtin is the University of Michigan professor who has directed the widely-referenced University of Michigan Consumer Sentiment surveys since 1976. When comparing the inflation of the 1970s with that of today, Curtin concluded:

Another critical characteristic of the earlier inflation era was frequent temporary reversals in inflation, only to be followed by new peaks.

That same pattern should be expected in the months ahead.

But let’s push back even against that.

After the most recent CPI report, President Biden boasted “the economy had zero percent inflation in the month of July [2022]”

And while the comment wasn’t wrong (month-to-month inflation was flat – which meant “0%”), it was egregiously misleading (year-over-year inflation was a nosebleed 8.5%).

But the comment is a great reminder of what’s important here – price, not inflation numbers.

For example, let’s say the CPI drops to 7%…but then stays there month after month.

Technically, month-on-month inflation will be wiped out – 0% – because the CPI is remaining steady.

But it’s remaining steady at elevated consumer prices that are draining bank accounts everywhere.

For example, if your grocery bill has exploded 25% over the last year, but then settles in at 18% above last year – with no more month-to-month increases – you’re looking at 0% new, month-to-month inflation.

Are you cheering this?

Of course not.

You’re still spending potentially hundreds of dollars more every month on groceries than you were a year ago…despite “0%” inflation.

The point is that inflation can’t just drop some. It has to keep dropping, month-after-month. But none of us can take that for granted.

Meanwhile, what about the shape of the U.S labor market 12 months from today?

Much has been made about the strength of the U.S. labor market. A common pushback to talk of a recession is “how can you have a recession with the unemployment rate 3.5%, which is the lowest rate in 50 years?”

Well, that’s the unemployment rate today. But what’s on the way? Remember, that’s what Wall Street cares about.

A survey from PwC released last week polled more than 700 U.S. executives and board members across a range of industries.

Here’s Bloomberg with the findings:

Half of respondents said they’re reducing headcount or plan to, and 52% have implemented hiring freezes.

More than four in ten are rescinding job offers, and a similar amount are reducing or eliminating the sign-on bonuses that had become common to attract talent in a tight job market. 

This is beginning now. And yet for two months, Wall Street has been partying like what’s coming is a continuation of 3.5% unemployment.

Speaking of the Wall Street party, just a quick word on the bullish surge that began in June…

According to Bank of America’s chief investment strategist Michael Hartnett, this rally has been a “classic bear really, and ultimately [a] self-defeating rally.”

In coming to that conclusion, Hartnett cites 43 bear market rallies since 1929 in which the S&P 500 gained more than 10%, with the average increase being 17.2%. Those surges lasted an average of 39 trading days.

This time, Hartnett points toward the index climbing 17.4% from a rally that lasted 41 trading days, which he calls “textbook.”

But at the end of the day, all of our analysis today is moot thanks to one overriding factor…

The Fed.

What we think is irrelevant. The only thing that matters is what the Fed thinks.

If, at the Fed’s September meeting, Powell & Co. deem that inflation is softening enough to ease up on hikes, then any disagreement from you or me is irrelevant. The Fed will soften and the market will likely take off.

But if the Fed is more hawkish than anticipated, Wall Street will likely act like a toddler who didn’t get his way, resulting in a sulking selloff.

But even then, that’s not the final chapter.

For example, imagine in September Powell says “we’re pleased with our progress and feel inflation has begun a sustained decline, though we shouldn’t declare victory early. We’re hiking by 50 basis-points, and will pause at the following meeting so we can assess the strength of the economic data.”

The market is likely to explode higher. You’re going to want to be in that rally.

But here are the questions investors need to ask…

Would such a market rally have any impact on the 50%+ of corporate managers laying off employees, rescinding job offers, and cutting bonuses?

Will that rally have any impact on energy prices, if a cold snap in the fall results in a surge in demand, which leads to higher prices across the nation?

Will that rally mean anything to the average working family with quickly evaporating savings and rising credit card debt?

But if the Fed says the data are improving, then the economy will be moving in the right direction. So is this perspective too bearish?

Maybe. But ask yourself: Do you really want to put all your weight on the group who brought you the classic hit “transitory inflation”?

The Fed has been wrong ad nauseam for the last 18ish months. Why are we to believe they’re suddenly going to nail it this time?

You have to remember that the Fed is under immense pressure to not wreck the economy

From its perspective, if you overshoot on rate hikes, a recession is guaranteed. Between that and “transitory inflation,” you go down in history as perhaps the worst Fed of all time.

Hmmm… not great. Is there another option?

Well, how about the Fed eases up on hikes to “see what the data tell us?” That would likely avoid an economic crash.

And if it turns out inflation remains elevated, crushing working families, well, that’s bad but it’s far less visible than a recession.

Plus, later down the road, you can always claim that data changed, forcing you to hike rates again at that point. You were “data dependent,” after all! And the data changed!

From the Fed’s perspective, that path holds some appeal.

It does for Kansas City’s Fed member Esther George, who just said:

We have done a lot, and I think we have to be very mindful that our policy decisions often operate on a lag.

We have to watch carefully how that’s coming through.

But what about the other Fed members who are basically saying “hike until inflation gets back to 2%”?

Well, we’ll be looking for clues about which side seems to be in control later this week at the Fed’s central banking conference in Jackson Hole, Wyoming.

So, circling back to the top of today’s Digest…

Is this a bear market rally or the real deal?

Well, in one sense it doesn’t matter.

If it’s a bear market rally but the Fed says all the right things next month, stocks are probably taking off.

If it’s a genuine bullish move today but the Fed is unexpectedly hawkish next month, stocks will likely screech to a halt.

But either way, that won’t be the end of the story.

Economic dominos are tipping over right now, and their paths and eventual impacts won’t fully be known for months to come – regardless of what the Fed does in September.

Here’s one illustration from Bloomberg last week as we wrap up:

The US mortgage industry is seeing its first lenders go out of business after a sudden spike in lending rates, and the wave of failures that’s coming could be the worst since the housing bubble burst about 15 years ago.

There’s no systemic meltdown coming this time around, because there hasn’t been the same level of lending excesses and because many of the biggest banks pulled back from mortgages after the financial crisis.

But market watchers nonetheless expect a string of bankruptcies broad enough to trigger a spike in layoffs in an industry that employs hundreds of thousands of workers, and potentially an increase in some lending rates.

Look beyond today’s short-term market direction and September’s Fed meeting. There’s more to the story.

Have a good evening,

Jeff Remsburg