Why the stock market isn’t impressed with the first monthly decline in consumer prices in more than 2 years

Considering that inflation has been one of the most consequential issues for markets over the past year, investors might have expected stocks to take off running.

Instead, after an earlier waiver, stocks finished Thursday with modest gains, the magnitude of which was much smaller than other recent CPI release days.

While the monthly CPI declined 0.1% in December, the annual gauge fell for the sixth month in a row to 6.5% from 7.1%. That’s the lowest level in more than a year and down from a 40-year peak of 9.1% last summer.

To get a better sense of what led to such a muted reaction in stocks, despite the economic milestone, MarketWatch collected insights from market strategists on what happened.

The ‘whisper number’

Perhaps the main reason stocks greeted the CPI data with disappointment was that investors had positioned for inflation to fall even more aggressively. Some even hoped that the drop would be large enough to prompt the Federal Reserve to reconsider more interest-rate hikes.

Ahead of the CPI data for October and November, economists had actually underestimated the degree by which price pressures would recede, on a year-over-year basis. And as prices for goods like used cars and for oil and other commodities declined late last year, traders anticipated they might be too conservative again in December.

As a result, a “whisper number” shared among markets professionals suggested that core inflation — which is the Fed’s main focus — would slow even faster than economists were expecting, according to Bill Sterling, global strategist at GW&K Investment Management.

Instead, the core level, which omits volatile food and energy prices, rose 0.3%, matching the median forecast from economists polled by The Wall Street Journal.

Options traders were too optimistic

Options traders had piled into bets that stocks would rise in recent weeks as the CPI data release neared, according to Charlie McElligott, a managing director cross-asset strategy at Nomura, who compiled data on options flows in a note shared with clients and reporters.

Shortly before the data release, McElligott said stocks could be “set up for disappointment” if the data came in “just in line” with expectations.

Traders have increasingly used options to trade CPI reports and other closely watched data releases, as MarketWatch has reported.

Report didn’t move the needle

Several markets commentators noted in the wake of the CPI report that the data didn’t fundamentally change expectations about where interest rates will peak, or how quickly the Fed will shift from hiking rates to cutting them.

After the report, traders of interest-rate futures bet on increased odds of the Fed slowing the pace of its rate hikes to 25 basis points in March. While they had previously seen such a move as extremely likely, they now see it as a virtual certainty.

But expectations about when the Fed might start cutting rates were relatively unchanged, with traders continuing to expect the first cut to arrive in the fall.

Perhaps the biggest reason for this, according to Sterling, is that the Fed wants to see a significant retreat in wage inflation before it’s satisfied.

Signs of slowing wage growth in December helped inspire a 700-point gain for the Dow Jones Industrial Average when the monthly labor-market report was released a week ago Friday. The report showed the pace of average hourly earnings growth over the prior year slowed to 4.6% in December from 4.8% in November. But markets had already priced this in, strategists said.

And while it’s certainly better for equity valuations than accelerating wages, Sterling pointed out that the Atlanta Fed’s wage tracker is still running at 6.4% year-on-year. That will need to fall substantially to satisfy the Fed, he said.

“The Fed needs to see wage growth retreat to closer to 3% to be convinced that its job is done,” Sterling said.

See: Why a stock market obsessed with the Fed’s inflation fight should focus on Main Street jobs in 2023

Valuations still too high

Finally, while lower inflation tends to benefit equity valuations, stocks still seem too richly priced based on previous periods of high inflation, said Greg Stanek, a portfolio manager at Gilman Hill Asset Management.

“The market loves when inflation comes down, that means a higher multiple,” Stanek said. “However, inflation is at 6.5%. That’s still too high to justify paying 17x for the market.”

The forward price-to-earnings ratio for the S&P 500 was 17.3 as of Wednesday’s close, versus a recent peak north of 24 in September 2020, according to FactSet data.

Over the past year, U.S. stocks have exhibited a strong response to CPI data. When the October CPI number beat economists’ expectations for a modest decline, the S&P 500 rose 5.5% in a single day. It was the largest daily gain of the year in 2022.

To be sure, markets tend to be forward looking, as market strategists like to say, and there’s always the possibility that traders views on Thursday’s data could evolve in the coming days and weeks.

In one recent analysis, a Deutsche Bank strategist examined U.S. stocks’ reaction to inflation data released over the past two years. He found that the market’s reaction becomes more muddled as time goes on.

While inflation has come in hotter than expected more than it has been below during the two-year period, “performance has been a bit more random than might have been expected,” said Jim Reid, head of thematic research at Deutsche Bank, in a note released ahead of the data on Thursday.

“In April 2022, the downside miss in the March reading saw a -9% selloff over the following month, whereas the same outcome for the October 2022 data released in November saw a +7% rally after the data came out on 10 November,” Reid said.

Stocks finished with modest gains on Thursday, with the S&P 500
SPX,
+0.34%
rising by 13.56 points, or 0.3%, to 3,983.17, while the Dow Jones Industrial Average
DJIA,
+0.64%
gaining 216.96 points, or 0.6%, to 34,189.97, and the Nasdaq Composite
COMP,
+0.64%
advancing 69.43 points, or 0.6%, to 11,001.10.