The S&P 500 has jumped more than 4% over the past week as we head into a significant CPI report Thursday morning.
The strength has been due in part to the "January Effect" when investors scoop up the worst-performing stocks from the prior year as tax-loss selling relents. This has been particularly helpful for many thinly traded small-cap names. Biotechnology names have been one of the major beneficiaries of this phenomenon.
The jump in the indexes is also due in part to positioning and optimism that CPI will continue to trend down. There are reports that hedge funds have been aggressively shorting technology stocks as we head into earnings season. There was likely some short-covering as the market runs up and looks anxious to celebrate any softness in the CPI report.
CPI hit a peak of 9.1% in June and has been dropping since then. Expectations are that CPI will decline 0.1% from November, but this is still a 6.5% annual rate and far above the Fed's ultimate target.
Core CPI, which excludes energy and food, is expected to increase by 0.3% in December, which is a 5.7% annual rate. That would be a decrease from the 5.7% annual rate that was hit in November.
Inflation is clearly dropping, and that is giving market players some hope that the Fed will pivot to a more dovish stance sooner rather than later. However, the market has consistently overestimated how willing the Fed is to shift to a more accommodative stance. The market has been fighting the Fed's very clear statements that it isn't going to proclaim victory over inflation prematurely. No rate cuts are expected this year.
Currently, there is an 80% probability that the Fed will increase rates by 0.25%, rather than 0.5%, at its next meeting on February 1. A soft CPI report will likely push this up close to a 100% likelihood, but the market is already expecting this. It has been priced into fed fund futures. The odds of a 0.25% hike have gone from 35% to 80% in one month.
While market players have been intently focused on peak CPI, they have ignored some other extremely important issues. The first is service-related inflation. The jobs market remains strong, and it is wage inflation that is a much more difficult issue for the Fed rather than consumer inflation.
We also have the problem of slowing growth due to higher interest rates, and we will soon see if corporate earnings estimates are too high.
Technically, the market is set up for a sell-the-news reaction to CPI, but poor positioning, a high level of shorting, and the January Effect may help to keep the uptrend running for a while longer. The market is widely expecting a soft CPI report. However, if the numbers are hotter than expected, there will be a very negative response.