Last week we had two inflation prints: one for the Consumer Price Index (CPI) and one for the Producer Price Index (PPI). While the headline grabber was that the monthly prints were above expectations (and they were) the Fed is nonetheless making considerable progress in its inflation fight as evidenced by both the CPI and PPI on a percent change from a year ago basis.

It seems to us that the trend is down even as we confront some stubbornness in the monthly releases. These things are always choppy, which creates some uneasiness. It might take longer than many expect, but we think in a year, the Fed will be declaring victory over inflation. The bigger threat at this stage is probably the effect of tighter financial conditions on broader economic activity and corporate earnings. So, let’s turn our attention to earnings.

 

 

Below is a chart showing the S&P 500 12-month forward earnings expectations (dark blue line) combined with the S&P 500 Index value (light blue line). As one can see, earnings expectations are declining even as the market is advancing. The central question is: will earnings expectations turn as the market seems to be presently predicting or will the market rollover as a deeper earnings problem sets in?

This is the central focus of almost all market pundits and strategists right now. The reality is no one has a clue what will unfold on the economic and earnings front if they are brutally honest with others and themselves. It could go either way. Things are murky right now.

 

But what we do know is that the market is expensive after the recent rally. Here is a picture of PE on forward earnings expectations:

 

 

The implication of an earnings cycle that appears to be in a downtrend combined with an advancing stock market is that, at the least, some caution is in order. We think the market has gotten a little ahead of reality. Our position is that we need to see hard evidence the economy has found level footing — the housing market should show signs of stabilizing while earnings and earnings expectations should stop going down. Also, importantly, the Fed should signal that its rate increases are over. Until these things happen, the uncertainty is high.

We continue to encourage caution during the intervening period. During this time, we are evaluating where we want to add to marginal risk when things improve. For the time being, we are maintaining our more defensive posture. As always, seek the counsel of your advisor if you want to assess your positioning in light of your goals and risk tolerance. We appreciate your business.

 

 

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