For a while now, the bearish narrative has been that inflation and higher interest rates would be the catalyst for an ugly market correction. Over and over, the bears would tell us "this will end badly" when the Fed provided more stimulus and maintained its dovish stance.
On Friday, it looked like bears would finally be rewarded for their pessimism as the market reacted negatively to the Fed's acknowledgment that inflation was hotter than expected and rate hikes would occur sooner than previously expected.
Once again, however, the market simply refused to embrace the negative narrative. While the bearish argument is logical and compelling, stocks produced an energetic bounce, and suddenly the view is that maybe these inflation worries aren't fully justified. The economy is strong, and many stocks are on track to produce some solid numbers. Maybe higher interest rates won't kill the economy.
On a macro level, inflation's effect is always an easy argument to make, but when it is viewed on a micro level and individual stocks are evaluated to judge the consequences, it often looks quite different. Higher interest rates hurt P/E ratios and raise borrowing costs, but it is easy to forget that the reason inflation is higher is because growth is so strong.
The debate over inflation and higher interest rates is far from over, and it will have some impact on the market as things move forward, but it is clear that this is not just a question of good or bad. Some stocks are going to benefit from higher growth, and inflation and others will suffer. There is going to be more rotational action as the issue is sorted out.
Despite the big bounce on Monday, there was mixed action in smaller stocks. The Russell 2000 ETF (IWM) outperformed, but the action was random, and there were pockets of weak and strong action. Liquidity seemed to be lacking in places, and that may be due in part to the upcoming rebalancing of the Russell indices.
The Russell indices will be rebalanced at the market close on Friday. There are trillions of dollars of stocks impacted, and it will be one of the highest volume days of the year. This rebalancing is going to have an impact on the rest of the week, and we are going to see some stocks move in anticipation of the shifts that are occurring.
We have a tricky trading environment as we deal with not only the issue of inflation but the rebalancing of the Russell indices. You won't hear much about the Russell indices from traditional business media, but this is a major market driver right now.
We have a mixed start on Tuesday as market players debate whether Monday's bounce was justified or not.