Shoppers in a Walmart store on Black Friday in Houston.
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Maybe inflation is transitory after all.
That wasn’t the expected conclusion from November’s consumer-price-index report, which came in a bit stronger than expected. Consumer prices rose 0.8% in November from October, topping forecasts for 0.7% while climbing 6.8% year over year, the highest rate since 1982. It was the blowout, superhot inflation number that everyone was expecting—and it was met with a shrug.
The major indexes, for their part, rose a touch on Friday to finish what turned out to be a fantastic week: The S&P 500 gained 3.8% to hit a new high, while the Dow Jones Industrial Average rose 4.0% and the Nasdaq Composite gained 3.6%.
But nowhere was the yawn bigger than in the bond market. The 10-year Treasury yield rose 0.001 percentage point to 1.487% on Friday, while the two-year yield slipped to 0.660%. Even the amount of inflation priced into Treasury inflation-protected securities declined. The bond market was sending a message, and it wasn’t one most people, fixated on the inflation rate, expected to hear: that inflation was nothing to worry about.
Of course, that contradicts what Federal Reserve Chairman Jerome Powell told Congress on Dec. 1, when he changed course and conceded that inflation, which has been running well above the Fed’s target, may not be a temporary phenomenon. A joker might have suggested that Powell’s capitulation was a sign that inflation was peaking. The bond market’s reaction suggests that it’s no joke. “The bond market is starting to tell you that there is not this urgency to raise rates quite as much,” says Andrew Slimmon, senior portfolio manager at Morgan Stanley Asset Management. “And that’s leading me to rethink how our portfolios are positioned.”
Even before November’s CPI was released, there were signs that inflation might be peaking. Commodities are a big part of inflation, and almost all of them have started falling from their peaks. David Rosenberg of Rosenberg Research tracks 30 commodities, including tin, wheat, gasoline, and, um, bran, and just four are currently making new highs: burlap, coffee, cattle, and milk. And while owner-occupied rents and the cost of shelter are still high and rising, Rosenberg doesn’t see them being too much of a long-term problem.
“Yes, yes, imputed rents and actual rents will be problematic for the next several months, admittedly, until the flood of multi-family units hits the real estate market in the second half of next year,” he writes.
If inflation is transitory, it suggests the emerging consensus about investing for higher inflation is wrong. Investors have only recently started positioning their portfolios for an inflationary environment, in part by selling off their high-valuation growth stocks. The logic is sound: Wall Street primarily uses a discounted-cash-flow model to price stocks, one that compares growth to a risk-free rate. If the risk-free rate is higher, then stocks whose growth is further out into the future are worth less, all else being equal.
That’s one reason stocks like PayPal Holdings (ticker: PYPL), Twitter (TWTR), and TripAdvisor (TRIP) have gotten whacked the past three months. It also explains why big tech stocks— Apple (AAPL), Microsoft (MSFT), and Alphabet (GOOGL) among them—have been rallying for little reason this month. “Growth stock managers have been forced to jettison high-octane companies and are buying safe tech stocks,” Morgan Stanley’s Slimmon says.
Being expensive hasn’t been enough for a stock to get hammered, argues Société Générale strategist Andrew Lapthorne. It has to be volatile too. “Being expensive on its own doesn’t seem to be an impediment to outperformance, but being an expensive and volatile stock is currently where we see the most downward pressure,” he writes.
Nowhere is the purging of growth more apparent than in stocks dedicated to software as a service. The RBC All-SaaS Index has dropped 24% during the past month, notes RBC analyst Rishi Jaluria, as companies like DocuSign (DOCU), down more than 40% after earnings, Zoom Video Communications (ZM), down 20%, and Salesforce.com (CRM), down more than 10%, suffer for sins real and otherwise. Many of the concerns are real. It’s unclear just what the future rate of growth at pandemic beneficiaries like DocuSign and Zoom will look like, but it’s also clear that expectations were so high that it took perfection, like that delivered by Snowflake (SNOW), which gained 16% on Dec. 2 after telling investors that its revenue would nearly double during the fourth quarter, for the stocks to move higher.
But big software selloffs have generally led to big bounces. Over the past five years, the average drawdown in the RBC All-SaaS Index of 24.7% has been followed by a rally of 28.7%. “When there has been a major selldown in software stocks, there has generally been a solid recovery after,” Jaluria writes.
Recent problems have been exacerbated by tax-loss selling, the phenomenon of investors selling what hasn’t worked and using the losses to offset capital gains. That too can provide an opportunity, notes John Kolovos, chief technical market strategist at Macro Risk Advisors. During the past five years, the worst-performing stocks in the S&P 500 during one year have averaged an 8% return during the first two weeks of the next. That could make stocks like Global Payments (GPN), down 42% so far this year, Penn National Gaming (PENN), off 43%, and Citrix Systems (CTXS), down 37%, among others, solid bets once 2022 begins.
“Past performance is no guarantee of future results,” Kolovos writes, “however, we think this idea is based on an assumption that can reasonably be expected again this year.”
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Of course, the bond market may simply have inflation wrong. The Fed, after all, is still buying bonds, which has a way of forcing longer-term yields lower, and as its influence wanes, yields should be expected to go higher. Perhaps the best course, after all, is to keep betting on high inflation by owning banks, energy stocks, and other beneficiaries of higher prices. No one should make sudden decisions based on one inflation report and one day’s response to it. The Fed, which is expected to accelerate its taper so that it ends by March, probably won’t change a thing.
But with so many growth stocks on sale, it’s a darn good time to start nibbling.
Write to Ben Levisohn at [email protected]
