It was a great week in the stock market. Thursday saw the largest single-day gain since March of 2020.
The S&P 500 gained over 5.5% and the Nasdaq gained nearly 7.5% on Thursday. Then, the market held and continued those gains on Friday. Which is great to see because it is pretty common to see the market go down after big days, as investors look to “take profits” and sell their positions.
All in, the S&P 500 – which is the best measure of the US stock market – finished the week up almost 5%. After being negative going into Thursday.
Softening Inflation
The big news on Thursday was a “lighter than expected” inflation report. The Consumer Price Index (CPI) came in at +0.4% on a monthly basis and +7.7% on an annual basis. Both of these were lower than consensus expectations of +0.6% and +7.9%.
Not that big of a difference. But, as I’ve been saying all along, we don’t need great news to drive the stock market up. All we need is for things to start looking a little better than expected. That is what happens when expectations become overly pessimistic, as they have been all year.
Continued Political Gridlock
There’s another big positive, at least from a stock market perspective. It appears we will continue to have political gridlock in Washington DC. As we await final results of midterm elections rolling in, it appears the Republicans will likely take control of the House and the Senate is still a dead heat.
A Democratic president and a Republican Congress means gridlock. Gridlock means it is difficult to pass any sweeping legislation that could impact the economy. This is good for corporate profits, as it reduces uncertainty and usually creates more effective business planning. Solid corporate profits and falling uncertainty are always a positive for the stock market.
Abundant Reserve Fed Policy
Many think stock market valuations are still too high. And this means the stock market has to go down further. They look at things like P/E ratio (and lately, a variation of this known as the Schiller P/E ratio has been highly talked about) of the overall stock market. And they claim it is too high, relative to historical norms. P/E ratio means the number you get when a company’s stock price is divided by its earnings. So if the price rises faster than a company’s earnings, the P/E ratio increases and it can appear that the price is too high.
But this fails to understand the concept of “abundant reserve” monetary policy, under which the Federal Reserve operates. Put simply, this means the Fed can change interest rates without changing the supply of money in the economy. So they can keep the system flooded with money at all times.
This was not the case in the past. In fact, up until the 2008 Financial Crisis, the Fed operated under a “scarce reserve” monetary policy. But, in 2019, they adopted abundant reserves as their official standard policy.
Why is this important? If there is a scarce supply of something, it costs a lot more. If there is an abundant supply of something, it costs less. And interest rates are simply the cost of money. Scarce policy leads to higher rates. Abundant policy leads to lower rates.
And lower interest rates reduce demand for bonds. Which increases demand for stocks. So, yes, the price of stocks is and has been higher than normal for a while now. But as long as we operate under abundant reserve policy, that should be expected.
Pending Recession?
This is the biggest risk to the stock market right now. Many are projecting we will enter a recession in the early part of next year. This could be the case. But remember, if people are talking about it, the market already knows about it. So this possibility is likely already reflected in stock prices. It is the reason we are currently in a bear market.
So, even if we enter a recession, if it’s milder than expected, the stock market would likely carry on with its ascent. We will see how this plays out.