The market got shellacked in trading Tuesday following a disastrous August Consumer Price Index (CPI) report that showed inflation was still much higher than expectations despite several interest rate hikes. It was the worst day for stocks since June 2020.
Core CPI advanced 0.6% from July and 6.3% from a year ago, which easily beat the consensus forecast. About the only good nugget from the report were falling energy and commodity prices as gasoline costs dropped just over 10%. However, grocery costs were up 11.4% from a year ago, which is the most since 1979. Electricity prices rose 15.8% from 2021, the most since 1981, and shelter costs -- the biggest component of CPI -- rose 6.2%.
Stocks fell hard as all chances for only a 50-basis-point rate hike when the Fed meets next week were taken off the table. There might even be cause for a 100-basis-point hike now, although the most likely scenario is for a 75-basis-point increase followed by another half-point rise in October.
Meanwhile, Ukraine seems to be recapturing a lot of lost territory thanks to a recent counter-offensive. While Ukraine's push rightfully is hailed as a battlefield success, I increasingly worry it also could cause Putin to cut off energy supplies completely to Ukraine' benefactors in Europe. This cudgel would be used to force the Europeans to put pressure on Ukraine to broker a peace deal. It would also send the European economy into a deep recession and further hurt the global supply chain.
I now see little chance that the United States can avoid a recession, perhaps a quite painful one. Option expiration on Friday will bolster the cash allocation in my portfolio another 5% to roughly 25% as many of my covered call positions expired in the money. I am also beginning to actively short overvalued stocks that are likely to be taken down significantly should the economy go into contraction. I should say "continued economic contraction" given the last two quarters have seen negative GDP growth. I am buying just out-of-the-money puts with expiration dates in the first quarter of 2023 to execute this shorting strategy.
On Tuesday I bought the January $120 puts on Paychex Inc. (PAYX) for $5.50 a share. Paychex stock closed Tuesday at $122.08. Paychex is a well-run company that supplies payroll and human resources services. As job growth slows or reverses, the stock is likely to be significantly impacted. This is especially true given the stock's valuation. The equity goes for 30x trailing earnings and 10x sales and has a free cash flow yield of about 3%.
Those numbers might be justified if Paychex was delivering stellar growth. However, management recently provided guidance of 7% to 8% sales growth and a 10% rise in earnings in the current fiscal year. That is growth Paychex might have tough time delivering if the employment situation worsens, which seems likely. In addition, there has been a sharp acceleration in insider selling since July. Even at 20x earnings, which seems more than fair, Paychex stock would trade around $85 a share. I can easily see a situation where I cover this bet and quadruple my money if recession triggers a selloff to the high $90s.
I see more of these sorts of contained short bets in the weeks ahead as the chances grow of a significant disruption to the markets.