That Obsession With Inflation Didn’t Last Long

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By Elena Popina and Sarah Ponczek

A $2 trillion rout in U.S. equities knocked investors out of a trance of profit euphoria. And they suddenly found themselves latching onto inflation as the thing to obsess about — until January’s CPI print came out Wednesday and they decided they weren’t interested in it, after all.

So maybe, they told themselves, the key to the market actually is strong fundamentals. Or weak fundamentals or overheating fundamentals or volatility traders or companies buying back shares or, heck, maybe it’s the Chinese Zodiac.

The stakes are getting higher — the S&P 500 just suffered its first correction since 2016 — but the narratives are getting squishier, the signposts harder to spot. Get used to it, says Walter Todd, the chief investment officer of Greenwood Capital Associates. This is what happens when economic cycles get old.

“The markets are having attention deficit disorder, they can’t figure out what they want,” Todd, chief investment officer at Greenwood Capital Associates, said by phone. “There is a lot of emotional reaction going on. Inflation data is one piece of the puzzle, but right now people are focused how this one piece will fit in, and I have to be wary of that.”

Behind all these different theories is a fairly simple story: 10 years of unprecedented stimulus from the Federal Reserve is being yanked, and nothing is as certain as it used to be. Violent reactions to each little data point are a sign that human emotion is back in control, with the backstop of monetary policy no longer as reliable.

“This is a market that is nervous,” said Quincy Krosby, chief market strategist at Prudential Financial Inc. “It doesn’t know what the Fed’s plan is.”

 

It was only last month that unprecedented profit upgrades spurred by President Donald Trump’s tax overhaul sent the S&P 500 to its biggest rally in two decades. Then that was history, lost in a tempest that pushed benchmark indexes down 10 percent. Obsession with earnings was replaced by obsession with inflation. Until Wednesday.

On Tuesday, futures on the S&P 500 tumbled as much as 1.3 percent, then surged as much 1.5 percent. Maybe that doesn’t sound nuts — but recall that in 2017, there was a 2 1/2-month streak when the index never closed up or down 1 percent even once.

It’s a lesson in the hazards of too much confidence about anything, when trading equities. What seemed reasonable in January — bidding stocks up after one of the biggest upward revisions to earnings estimates — looked like a mistake by February.

Not that the inputs aren’t real. The passage of Trump’s tax cuts triggered an unprecedented wave of earnings revisions. From $145.90 a share in mid-December, analysts raised 2018 earnings projections to $156.20, with the technology and financial sectors contributing the most to the jump.

“We have gone from this single-dimensional environment of positive earnings expectations to a more normal environment,” said Gina Martin Adams, chief equity strategist at Bloomberg Intelligence. “We’re weighing all the various factors that could have an impact on stocks.”

Bank of America’s Dan Suzuki had doubts about building a giant bull case on analyst estimates that will need up to two years to materialize. Equity strategists at the bank studied the performance of the S&P 500 over 90 years and found that less than 20 percent of the market’s annual performance is even driven by earnings growth. U.S. stocks were down in 29 of the past 90 years. Of those 29 times, per-share earnings were up almost 70 percent of the time.

At the same time, the threat of inflation is rising. Yields on 10-year Treasury rates are approaching 3 percent, a gain that if nothing else dents a valuation case on equities tied to how much more you get in corporate earnings than bond payouts. After the CPI, traders used eurodollar futures to express a view that central bankers have a clearer path to tighten.

Too Optimistic?

From 2007 to 2017, analysts’ EPS growth estimates were on average 7.4% higher than the realized pace of EPS growth

The consumer price index rose 0.5 percent from the previous month, above the median estimate of economists for a 0.3 percent increase, a Labor Department report showed Wednesday. Concern that rising wages will spur inflation and push the Fed to tighten faster rose after strong jobs data on Feb. 2 sent bond yields soaring and equities plunging into the first correction in two years.

The fact that the inflation reading came in above estimates and yet was unchanged from December was the reason the market went berserk following the release of the data, as traders, spooked by last week’s selloff, struggled to figure out what happens next, according to Michael Antonelli, an institutional equity sales trader and managing director at Robert W. Baird & Co.

“The market is super sensitive right now, given ‘rates rising’ was the impetus for our giant selloff,” Antonelli said. “We’ve been burned just last week, and now we step back up to the stove to cook again, and we’re nervous. With the memory of being burned, we recoil in horror.”

 

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