Stocks Can Rally As Long As Oil & Rates Fall

The stock market opened lower today, but turned around quickly as oil prices began to turn over. WTI crude oil started the day around $89/barrel, then stumbled toward $86. Consequently, the S&P 500 went from -.4% to +.3%. The bond market is selling off across the board—short-term, long-term maturities, Treasuries, corporates, and junk. Yields are on the rise.

When it comes to interest rates and bond yields, there is considerable debate about whether we investors should be heeding the Fed’s message, or signals derived from bond market trading. The Fed has consistently said it will continue to raise interest rates as high as necessary to break inflation. This will, of course, slow the economy and probably won’t push it into recession. There is much “wood to chop” since inflation is now close to 9%, the Fed’s target is 2%, and the Fed-funds interest rate is just 2.5%. One might reasonably expect Fed-funds to climb to 4% or more in order to break inflation.

But on the other hand, trading in the bond market suggests rates will peak at a relatively low level and fall as the economy slows. The current yield on the 2-year Treasury note is about 3.2%, and yields on the 5-year and 10-year notes are incrementally lower than that. Said differently, Bankrate’s average 30-year fixed mortgage rate shot up from 3.27% at the beginning of the year to 6% in mid-June. But since then that rate has fallen back to 5.5%. It’s almost as if the Fed is screaming, “Look out, rates are going to keep rising!” But the bond market is shouting back, “No they won’t—you’ll push the economy into recession soon and rates will fall back!” In our view, the economy is definitely slowing and recession is a coin flip. But beating inflation without having to raise interest rates to very high levels (i.e. mortgage rates over 6.5%, credit card rates over 20%) is preferable. I’ll take the bond market’s message.

Second quarter earnings season has been pleasantly surprising for investors. About 450 of the S&P 500 companies have reported results, with about 63% of them beating Wall Street sales forecasts, and 75% beating profits forecasts. Of course, the economy is slowing but it looks like corporate America is managing to keep profit growth positive. Wall Street’s consensus expectation for aggregate profit growth is currently about 8% for 2022 and 7.5% for 2023. I think it’s fair to say earnings season has helped fuel the stock market rally we’ve seen since mid-June.

Home Depot (HD) stock surged more than 3% after the company reported better than expected second quarter results. The home improvement chain posted 6.5% sales growth, driven by a 9% hike in average transaction value. Management noted continued strong demand for home improvement products. But the quarter was not without “hair” as analysts say. The total number of transactions fell by 3%. So while inflation is driving up sales, it is also true that customer traffic is falling. Inflation is apparently curtailing demand for big-ticket items like grills and mowers, but other categories are doing quite well. Nevertheless, this is a clear example of why professional investors say the stock market is a decent hedge against inflation.