The S&P 500 closed lower again last week, but as we mentioned last Tuesday, don’t be surprised to see some additional volatility in the market over the next few weeks.

Frankly, we are surprised that the market was so calm. Although it didn’t get a lot of press, the Fed started its Quantitative Tightening (QT) campaign last Wednesday, which will presumably continue this week as well.

Right now, the Fed holds nearly $9 trillion in treasury, corporate, and mortgage bonds. They did this to try and stimulate the economy and have built that portfolio since 2008 when Ben Bernanke was Chairman.

The Fed can only reduce its holding by selling bonds. According to the “laws” of supply and demand, assuming everything else remains the same, if you increase the supply of bonds, the price of bonds will fall. We think this is going to make it another tough year for bond investors. Additionally, when bond prices fall, long-term interest rates rise… which is bad for everyone.

The Fed’s board says they will try to sell $95 billion in bonds each month. However, in our experience, what the Fed says it will do and what happens are two different things. If the selling is too disruptive to the market, they will slow down, but things will be rocky in the meantime.

This may sound dire, but it’s not all bad news right now.

Retail and labor reports were very good last week, but those are more likely to keep a floor under stock prices than to send the market higher. In our view, it will take confirmation that inflation is beginning to ebb for prices to start creeping back up to the prior highs.

June is always a little dry for new economic or earnings data. However, there are a few announcements to keep your eye on that could help increase our confidence that we aren’t going to see new lows in the market this summer…

• Wednesday, June 8

Every Wednesday, the Energy Information Administration releases its oil inventories number. This is a measure of the change in the number of barrels of oil held by industry. This is not a report that traders usually pay much attention to, but this is an unusual market, and it definitely matters right now.

What investors would like to see is an increase in inventory. This means that companies overestimated energy demand. That sounds bad, but right now it is a good thing. If companies are storing more oil inventory, then prices should drop a little while companies use their inventory or sell it off.

Energy prices have been creeping back up to their highs since mid-April. We have even seen reports of gasoline prices at the pump closing in on $10 per gallon in California. Energy costs are a significant source of inflation; the more consumers are paying to fill their vehicles and for travel, the less they are spending on other consumption, which is bad for stocks.

• Friday, June 10

Another Consumer Price Index (CPI) inflation report will be released by the Bureau of Labor Statistics. Right now, economists are expecting to see annualized inflation in the 8.8-9% range. If inflation meets or exceeds these expectations, we think traders will have a very negative reaction, which could send the market lower heading into the weekend.

The Federal Reserve is meeting next week to announce the next round of rate hikes. There has been some recent improvement in inflation measures lately, but we are concerned that Friday’s numbers will have been pushed much higher because of rising energy costs.

What You Should Do

We have been recommending that investors focus on large-cap value and consumer staples stocks right now. Last week, we expanded that to semiconductor stocks for investors willing to tolerate a little risk. Although our outlook for this week is cautious, we stand by that position.

Energy also still looks good, and we still think the big natural gas producers are the most likely to benefit portfolios in the long term. However, oil companies and refiners are overbought right now and have more downside risk than upside potential in the short-term.

Bottom Line

There isn’t much news this week until Friday when the next inflation report is released. This may help keep volatility a little lower, but we don’t expect to see a big move to the upside. For now, investors are still waiting for evidence that inflation has fallen enough for the Fed to ease off faster interest rate hikes before sending stocks much higher, and we don’t think that evidence is going to appear this week.