The Stock Market May Have Hit Bottom. Here’s Why.

There was a case for some optimism on Friday, with all three major indexes gaining more than 1% as investors dialed back their expectations for a full-point rate increase by the Federal Reserve to fight rapid inflation. The indexes continued to rally on Monday until Apple (ticker: AAPL) announced it would slow down hiring and spending growth next year as economic demand wanes.

The news wiped out all of the earlier gains for the day, with the S&P 500 down 0.8%. The

Dow Jones Industrial Average

fell 0.7%, and the

Nasdaq Composite

0.8%.

Now, the debate is about whether the market has hit bottom, or if there will be another wave of selling that will bring fresh lows. 

The bull—or optimistic—case starts with the narrative that inflation may have peaked.

The consumer price index rose 9% year-over-year in June, even after having gained over 8% in May. But commodity prices have tumbled in the past month, with oil and copper down 17% and 33%, respectively, from their 2022 peaks.

Not only could that indicate that the Fed’s policies—pushing short-term interest rates higher—are beginning to dent economic demand, but oil represents about 12% of the CPI basket of goods and services, which means it could drag the CPI lower. 

The main reason the “peak inflation” narrative is so key for the stock market is because it means the Fed would be less aggressive than feared.

While the Fed might lift the federal-funds rate by a full percentage point, rather than the three quarters of a point lift seen a few weeks ago, odds of that have dropped in the past few days.

Plus, the fed funds futures market is reflecting a peak rate of about 4% and the possibility for rate cuts next year. That could provide relief for the economy—and the stock market. 

“Whether the FOMC raises interest rates by 75 or 100 basis points a week from Wednesday is much less important to stock prices than where markets believe the Fed will stop the current rate tightening cycle,” writes Nicholas Colas, founder of DataTrek. 

Consistent with the peak Fed-tightening and peak inflation narrative, long-dated bond yields are also below their highs. The 10-year Treasury yield is just below 3%, after having hit a multiyear high of about 3.5% in mid June. That is key for stock valuations, as the S&P 500’s aggregate forward price/earnings multiple has stabilized at about 16 times, down from just over 20 times to start the year. 

Evidence that stock valuations are already reflecting the worst of the risks quietly emerged last week. On July 13, the consumer price index posted its highest gain in decades, but the stock market recovered much of its losses and the Nasdaq Composite ended the day down only 0.2%. That means the market had already reflected much of the economic threat that the inflation brings.

“Last week’s muted response to the latest unpleasant surprises in June’s CPI …suggests that lots of investors already bailed out of the stock market,” writes Ed Yardeni, founder of Yardeni Research.

The bearish call hinges mostly on the idea that earnings estimates must drop.

The aggregate 2022 earnings per share estimate for S&P 500 companies is up for the year, while interest rates have risen and calls for a recession have gotten louder. Already, analysts have begun to lower expectations, with the 2022 forecast down 0.33% in the past month, according to FactSet. 

“The bears …contend that there is still much more downside ahead for stocks since industry analysts are only now starting to cut their earnings estimates,” Yardeni writes. 

The good news is that this may also be reflected in stock prices.

“There shouldn’t be a lot of downside in the stock market stemming from downward earnings revisions,” Yardeni writes.

Sure, there might be some pain ahead. But that doesn’t necessarily mean fresh lows. 

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com