We live in a world of clickbait: Everything must be a crisis, and all is exaggerated. It gets very tiresome. On Tuesday the market dropped dramatically because of the “HOT” inflation report. The Consumer Price Index came out indicating that inflation is running at an annual rate of 3.1 percent. So-called core inflation, which is prices not including energy or food, rose 3.9 percent. So, is that hot?
The story is that this is a bad report because it was higher than expected; the expectation was for inflation to be 2.9 percent and for core inflation to be 3.7 percent. So, relative to expectations we were a whopping 0.2 percent higher. However, based on the previous readings, inflation went from 3.4 percent to 3.1 percent. It was 3.7 percent as recently as September. Core inflation remained the same.
Inflation is not actually heating back up, it is cooling; it simply did not cool as quickly as predicted. In the real world, things do not move in straight lines. Have you ever had to click that box online that says, “I am not a robot?” That test seems silly…couldn’t a robot simply click the box? It turns out that clicking the box is not the test. The test is the path one’s curser travels to get to the box, since only a robot can use a mouse to move the curser in a perfectly straight line. Inflation (as all economic data) reflects human activity: We don’t move in straight lines, thus neither does the data that reflects our activity. We humans do, however, move in a general direction; there is a trend, and the trend for inflation remains down.
The market pundits remain fixated on the Fed and interest rates, and they worry that a slower drop in inflation means rates stay where they are for longer. In our opinion, this worry is misplaced. Stock prices are determined by earnings. It is not that interest rates do not matter, they do – companies have to borrow money, and the interest that they pay will reduce earnings. Additionally, investors who calculate the future value of a company do so with what we refer to as a discount rate. The easiest way for non-mathematical people to understand this is that the potential return on stocks must be compared to what one could earn collecting interest from a very safe bond. If the rates on the bond are higher, then investors will theoretically be less willing to buy stocks, which drives prices down.
Do these worries make sense? The first concern does not. As long as the economy keeps growing, then companies will continue to grow earnings. The initial reading for the fourth quarter GDP came in up 3.3 percent. The real-time reading from the Atlanta Fed’s GDPNow is 3.4 percent. Current interest rates are not stopping growth, so the idea that they must be cut for growth to occur is simply wrong.
The discount rate issue is also greatly exaggerated. Most investors are using the 10-year Treasury for their discount rate. We do so because investing (as opposed to trading) is a long-term endeavor. The 10-year is in a range around 4 percent; this was normal before the Fed took extraordinary measures in response to the 2008 financial crisis, which was then deemed the “new normal.” After Covid they said it was a new-new normal. Today we are in the normal-normal, and that is not restrictive for stocks.
Lastly, I feel confident saying the market pundits are wrong, because the market itself keeps telling them they are wrong. I am not sure how long they can all stay wrong and still be employed, but I assume that they believe there is safety in numbers.
We are all human beings. We get it wrong sometimes at Iron Capital too, but we climbed out on a limb in 2023 when seemingly all the pundits were calling for a recession: we were right, they were wrong. Thus far in 2024, that is another trend that continues. We are not doing anything magical over here, we are simply ignoring the headlines and paying attention to reality.
Warm regards,
Chuck Osborne, CFA
Managing Director
