After yesterday’s wild stock market rally then crash, everyone’s naturally worried about the Fed. But all this hype about the Fed and its rate hikes, economic projections, and rhetoric is really just much ado about nothing?
I know that sounds silly. The U.S. Federal Reserve is the most powerful financial force in the world. I’ve previously called Jerome Powell and his colleagues the masters of the financial universe.
But a few months back, Powell himself said the Fed has shifted to a “data-dependent” policy stance. When that happened, I stopped paying such close attention.
Why? In becoming data-dependent, the Fed has become an output, not an input. It’s become a lagging indicator, not a leading one.
So, what’s the leading indicator? Inflation.
Forget the Fed. Focus on inflation. That will allow you to separate the noise from the signal in this market. Then you can make money despite today’s prevailing volatility.
Here’s a deeper look.
The Fed Is Reacting to Inflation
Let’s not confuse things here. The Fed wields the most power in the financial universe. However, it’s currently using that power – rate hikes – in a reactive way.
The Fed isn’t raising interest rates to store some rate cuts for a rainy day. That was the case back in the 2016-18 and the pre-08 rate-hike cycles. The central bank wasn’t fighting inflation in either of those cycles. It was being proactive – not reactive.
In the current U.S. economy model, then, the Fed’s actions are an output. Inflation is the input. You don’t predict outcomes by looking at outputs. You predict them by looking at inputs. The inputs determine the outputs. If the input changes, the output does, too.
In our case, if inflation stays hot, the Fed will stay aggressive. If it cools, it’ll back off with the rate hikes.
And so everything comes back to inflation. Inflation – not the Fed – is what matters in markets today. If inflation falls, all the stock market’s problems will be solved. If it doesn’t, the stock market is in major trouble.
Understanding this simple reality will allow you to separate the noise from the signal in this market mayhem.
I can guarantee that over the next several months, stocks will have several weeks when they rally big and several weeks when they crash big. I can also guarantee that only a few of those rallies and crashes will be meaningful. Most will be noise.
How can you tell the difference? You see if the move is driven by inflation. Inflation-driven moves in this market will prove durable. Most other moves are just noise.
With that in mind… what’s the outlook for inflation over the next few months? Lower – a lot lower. That means the outlook for stocks is higher – a lot higher.
A Massive Disinflationary Wave Is Building
Just a few days ago, research firm Capital Economics released a very interesting research note. In it, the firm’s economists talked about why they feel a massive disinflationary wave is building in the U.S. economy.
The big points? Oil, metal, and food prices are crashing. Energy and transportation costs are falling. And supply chains are rapidly normalizing.
Of particular interest, the firm’s proprietary product shortage indicator – which has historically been a strong leading indicator of core inflation – has been plunging. If this powerful correlation between the Capital Economics product shortage indicator and core inflation rates persists, then core inflation could fall back to 2% before the end of this year.
We entirely agree with this thesis and would like to add a few points.
In addition to plunging commodity prices and improving supply chains, consumer demand is weakening due to high inflation and aggressive rate hikes from the Fed. Considering the Fed is married to more rate hikes, consumer demand will likely weaken further.
As a result, inventory gluts are a huge problem now, too. Many retailers overordered goods on the idea that 2021 economic demand would persist. But it’s crumbling, so inventory levels are elevated. And now retailers need to clear that inventory via discounts.
Wage growth has slowed meaningfully, too. The labor participation rate has rebounded. Hiring surges have turned into layoff announcements. And labor market negotiation dynamics are now shifting back in employers’ favor.
Lastly, shelter costs are starting to fall. Most data suggests that home prices peaked in June and have been falling in July, August, and September. And most data also suggests that rents peaked in July and have been falling in August and September.
Given all these factors, we agree with Capital Economics. A massive disinflationary wave is building.
If so, an equally massive stock market surge could be just around the corner. And that’s regardless of how the market reacts to the Fed over the next few days.
The Final Word on the Fed
The stock market moves every day. Not all those moves are meaningful. In fact, on most days when the stock market either rallies or drops, it isn’t meaningful. It’s just noise.
One of the keys to winning on Wall Street – when times are good or bad – is to accurately separate the noise from the signal.
In other words, discern which market rallies and crashes are significant and which aren’t. Then, ride those significant moves, and fade the insignificant ones.
In this market, significant rallies and crashes are those driven by inflation data. Most other rallies and crashes are just noise.
The next big inflation data to hit the tape will be October 13 with September’s CPI. Whatever’s reported that day will be far more important than what the Fed said yesterday.
We think that report will be very soft. Therefore, regardless of what the market does over the coming weeks, it could be bracing for a massive October rally.
If so, we have the perfect stock for you to buy right now ahead of that rally.
On the date of publication, Luke Lango did not have (either directly or indirectly) any positions in the securities mentioned in this article.