The stock market enjoyed a rally in October, rising even in the face of yet higher inflation and interest rates. The S&P 500 gained 8.1% for the month but still has a year-to-date return of -17.7%. Mid and Small caps performed well too, gaining 10.5% and 12.4%, respectively. International Developed Markets were similarly strong, but Emerging Markets disappointed with a -3.1% return driven primarily by declines in Chinese markets on the heels of the latest Chinese Communist Party National Congress. Bond Markets did not participate in the rally, however, as rising interest rates continued to place pressure on fixed income assets. The yield on the U.S. 10 Year Treasury rose over the course of October from 3.80% to 4.1%. The yield on the U.S. 2 Year Treasury rose from 4.22% to 4.5% during the month, and even the 3 Month U.S. Treasury rate exceeds the 10 Year, it finished October yielding 4.2%.

With another shock inflation report on October 13 (CPI was 8.2% vs. an expected 8.1%), it might be confusing to investors why stocks still had such a strong month. One strong theory is that technical forces and seasonality contributed to the rally. Stocks sold off for six consecutive days leading to the bottom on October 13^th, Bank of America’s Global Fund Manager Survey indicated the fund managers had built up the largest cash positions held in over two decades, and the AAII Investor Sentiment Chart had fallen once again this year to extreme lows. All of these factors suggest oversold conditions in the market that sparked a rally. Additionally, it seems that the Fed is increasingly acknowledging the need for a pause of rate hikes in the next few months. Even the more hawkish members have referenced the need to let actions already taken filter through the economy before tightening too much. The current expectations suggest that the Fed will hike another 75 basis points in the first week of November, 50 basis points in December, and then either keep the rate steady or perhaps a 25 basis point hike through the entirety of Q1 2023. This deceleration of policy tightening can be taken as a bullish indicator for stocks, but investors should be mindful that the Fed’s course will depend on inflation and thus could become more hawkish if warranted. The minutes and press conference following the Fed’s meeting on November 2 will be important for market expectations. Another potential catalyst for the October bull is that there have been some economic releases that suggest inflation is beginning to soften, contrary to the October 13 print of September’s CPI. Home prices fell by 0.7% month over month in August—data received in late October—marking the single largest monthly decline in the Case-Shiller housing index ever seen. If that trend holds through September and October, it will represent clear evidence that rising interest rates—including mortgage rates that now average over 7%-- are beginning to have an impact on demand. This coupled with a decline in agricultural and energy prices in recent months, suggests that the underlying drivers of inflation are beginning to taper, even if the lagging indicator of CPI is still persistently high.

Another factor that may be contributing to the recent market rally is a somewhat benign earnings season. It’s not that earnings have been spectacular—in fact, tech giants like Meta, Alphabet and Amazon were crushed following disappointing earnings—but taken broadly, things continue to look relatively strong. There is no widespread signaling by corporate executives of a hard landing recession hitting their businesses. According to FactSet, through October 28, with 52% of companies in the S&P 500 having reported Q3 earnings, the blended earnings growth rate in Q3 is on track to be 2.2%. More importantly, forecasts for S&P 500 aggregate earnings in 2023 are sitting at $238 earnings per share. This is a far cry from an earnings collapse wrought by recession.

What are the big question marks going forward? For one, even if inflation is beginning to soften, will it soften enough to satisfy the Fed that it has achieved the “terminal rate”, beyond which they won’t hike anymore? 5% CPI is much better than the recent 8.2%, but it’s still well above the Fed’s stated target of 2%. Another question is: how well can the economy tolerate rates at their current levels, perhaps even a full percent higher? While the signs of softening referenced above are encouraging for the purpose of corralling inflation, they are concerning as they might potentially be the initial cracks that lead to a wider, deeper economic downturn. Finally, even if you grant that the U.S. can achieve a relatively “soft” landing without a significant decline in earnings, what is the appropriate valuation for stocks in this new interest rate environment? It was much easier to justify a 21.4 price to earnings ratio on the S&P 500 at the beginning of the year when Treasury yields were next to nothing. With Treasury yields now above 4% across the curve, valuations must surely remain compressed. According to FundStrat, the average P/E ratio on the S&P 500 when the 10 Year Treasury is around 4% is 19. When it’s at that level during a Fed tightening cycle, it is 18.5. Either way, if earnings hold and Treasury rates don’t go much higher than their current levels, history suggests the S&P 500 needs to increase in value from its current P/E of 16.3.

It is easy to conceive of two very different market outcomes between now and year end. In the bright scenario, stocks continue to rally on the narrative of softening inflation and a Fed pause. The rally could even be further propelled by the midterm elections getting behind us, removing one more piece of uncertainty. In the grim scenario, CPI continues to surprise market observers to the upside, perpetuating the sense that the Fed is still behind the curve and will need to accelerate their tightening plans once again. Investors should be prepared for either outcome by continuing to match their investment portfolio risk that their own comfort level and investing goals.

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