What’s Wrong With The Stock & Bond Markets?

April has been tough for stocks and bonds. The S&P 500, Dow and Nasdaq are off by about 4%. High-grade corporate bond prices have fallen about 3.5% while long-term Treasury bonds are down 7% this month. Coming on the heels of a strong 5-month rally, does this signal an end to the party?

The trouble started when the Bureau of Labor Statistics released March inflation data. The Consumer Price Index (CPI) surprised us by accelerating to an annual rate of 3.5%. We’d become so accustomed to a gradual progression of lower inflation readings that it came as a bit of a shock despite some other recent signs of higher price growth. Bloomberg News worried that “US Inflation Refuses to Bend, Fanning Fears It Will Stick.”

Federal Reserve Chairman Jerome Powell was apparently surprised as well, because he abruptly changed his tune about planned interest rate cuts. He noted that “recent data have clearly not given us greater confidence” that inflation is on a path to the 2% target. Investors interpreted that to mean, “You can forget about interest rate cuts for the immediate future.” Yet again, we find ourselves in a wait-and-see situation for the Fed.

Adding to the complexity of the moment, we learned today that economic growth unexpectedly slowed during the first quarter. Gross domestic product (GDP) ticked down to a 1.6% annual rate from 3.4% in the prior quarter. That’s certainly not the end of the world, but the kicker was that GDP’s inflation gauge moved up to 3.1% despite slower growth. So traders’ knee-jerk reaction was to cry “Stagflation!”

All this has conspired to push interest rates higher, driving bond and stock prices lower. The 2-year Treasury bond yield shot up to 5%, and the average 30-year fixed mortgage rate climbed back to 7.5%.

The Wall Journal characterized the CPI and GDP reports as “disappointments” and even “rude awakenings,” but said they’re “not enough on their own to dramatically change the outlook for the Fed.” That outlook calls for continued strong economic growth and gradually decelerating inflation. True, these latest reports seem to suggest a contrary trend. But remember, nothing in the economy or capital markets moves predictably in a straight line. And anyway, the data aren’t really as bad as the market reaction suggests. For example, the GDP report showed that consumer & business spending are healthy, but overall growth was hampered by -1.3 percentage points of business inventory & trade adjustments.

Back to the question at hand: is the party over? I think not, but it may be interrupted for a bit. I’ve just listed some reasons for the selloff, but they might as well be called excuses. The fact is, we are due for a correction. Remember, from Halloween through the end of March the S&P 500 and Dow soared by more than 20%–a huge move in a short period of time. In addition, history tells us that the stock market suffers through one 10% correction per year, on average.

Viewed another way, the stock market is self-correcting to reset valuations. From Halloween until the end of March, Uber (UBER) shot up 78%, Caterpillar (CAT) rose 62%, and Disney (DIS) climbed 50%. These and other stocks had arguably become expensive relative to their fundamentals (i.e. sales, cashflow & profit growth). So it’s not surprising to see them give back some of that outperformance.

Now that we’re in the middle of earnings season, stock prices are adjusting to 2024 expectations. So far, results are fairly encouraging. Of the roughly 190 S&P 500 companies that have reported first quarter results, about half have beaten sales projections and 80% have exceeded profit expectations. Most CEOs have reaffirmed prior guidance for the rest of the year rather than increasing or slashing expectations. And their message on the economy is clear: demand remains strong.