Bullish investor sentiment exploded when the Federal Reserve started cutting interest rates.
The Fed surprised investors with an outsized 0.5% rate cut to kick off its easing campaign back in September.
In response, the S&P 500 quickly jumped to new all-time highs.
The market widely expects the central bank to cut interest rates by another 0.25% at its final meeting of the year next week.
The ongoing cuts are fueling investor hopes that lower interest rates are in store for next year as well.
But just as quickly as the Fed cut rates, it might be forced to stop.
That’s because a hallmark of the last bear market is making a comeback…
An Inflation Comeback?
In comments made last week, Fed Chair Jerome Powell hinted that rate cuts may come at a slower pace going forward.
Powell stated, “[The] economy is strong and it’s stronger than we thought it was going to be in September.”
While the economy may be one factor for slowing cuts, the real reason comes down to something else.
The Fed’s battle against inflation is stalling… if not outright failing.
There’s been a lot of progress on the inflation front since the Consumer Price Index (CPI) peaked at 9.0% in June 2022. Since then, it has fallen to an annual gain of 2.6%.
But economists pay close attention to “core” inflation. It strips out volatile food and energy prices.
This helps determine underlying inflation trends.
The CPI looks at consumer inflation. The Producer Price Index (PPI) looks at inflation for domestic producers of goods.
The core PPI stopped falling a year ago (blue line in the chart). Core CPI is now turning higher as well (red line).
Both core figures also remain well above the Fed’s 2% inflation target.
Rising inflation is derailing the Fed’s plan to cut interest rates.
And rising inflation can derail investors in other ways as well…
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Stocks Are Vulnerable
When inflation started accelerating into 2022, the Fed had to raise interest rates to their highest level in over two decades.
High inflation and interest rates wreaked havoc on the stock market.
From high to low, the S&P 500 fell by 25% in 2022. The core CPI peaked at 6.6% in September 2022.
During periods of high and rising inflation, the impact on technology stocks is even worse. In fact, the tech sector is the third worst-performing S&P 500 sector in such environments.
During 2022, the Invesco QQQ Trust, Series 1 (QQQ) – which is heavily weighted in tech and growth stocks – fell as much as 35%.
If inflation keeps rising, the stock market impact could be even worse this time around… especially in tech and growth.
No surprise, high levels of inflation harm stock market valuations.
The higher the inflation, the lower the multiple on things like the price-to-earnings (P/E) ratio.
Large-cap growth stocks currently trade at a P/E ratio of 29.
That’s 51% above the 20-year historical average. That growth segment of the market is more overvalued relative to its history than any other.
The technology sector also trades at a P/E ratio of 29, which is the most expensive of any other market sector.
Those types of excessive valuations are making stocks even more vulnerable to the impact of inflation.
So keep a close eye on inflation trends.
Accelerating inflation could create headaches for the Fed and investors alike as we head into 2025…
But rest assured that, as traders, we’ll have plentiful opportunities to take advantage as markets adapt to these conditions.
Happy Trading,
Larry Benedict
Editor, Trading With Larry Benedict