June 18, 2023

The Rally of the Rest

A business owner engaging in tug-of-war with an AI robot hand

Bottom Line


The Fed rightly paused its interest rate hike campaign this week as inflation continues cooling quickly. Markets surged higher, pairing disinflation news and economic acceleration news with rising corporate earnings estimates. Should these trends continue, cash-heavy investors must choose their moment and method for reinvestment. Fortunately, while the AI hype-infused, mega-cap growth stocks have yanked the S&P 500 to lofty return and valuation levels, the non-S&P 500 return and valuation levels offer plenty of scope for advancement.


Those committed to “higher for longer” inflation fears need to spend some time reviewing history. Rapid declines in inflation have always followed rapid advances. As such, inflation’s downward momentum will continue, the Fed’s tightening campaign will end, and the stock market’s advance will broaden and deepen beyond just mega-cap technology names. With inflation on the ropes, and the Fed on pause, it’s time for the rally of the rest.


The Full Story:


This week the Federal Reserve paused its interest rate hiking campaign while tightening its rhetoric. The algorithms sold the bark aggressively, with immediacy, while the humans bought the lack of bite aggressively, with delay. By the end of the week, the S&P stood 3% above where it began. For investors clinging to their pessimism like rosary beads, this rally has become excruciating.


The second quarter ends in two weeks with the S&P now up 16% on the year. Clients will open statements expecting returns. Pressures will mount upon pessimistic professionals to either double down on their pessimistic forecasts or capitulate. Within the past two weeks, the economy has shown resilience, inflation has slowed substantially, the Fed has hit pause, and forward earnings estimates are rising. While this market has become highly technically overbought, pullbacks will provide cover for capitulators, likely limiting their severity. But where will the money go?


Beyond the Hype


Despite the hype, those now entering the stock market supermarket will find some surprising bargains. They will not find them in the AI aisle, but they will find them nearly everywhere else. Consider the following valuations across investable market segments along with their year-to-date returns:


A chart listing PE Ratios and Year to Date Returns on Market Segments


The valuation and performance differential between the mega cap driven S&P 500 and the non-S&P 500 segments provide ample mean reversion opportunities. For the mean to revert, either the megas need to catch down, or the rest of the market needs to catch up. Given the revival in economic and earnings confidence over the past couple of weeks, the catch-up trade has cause and traction. Note the June performance for the groups above:


A chart listing PE Ratios and Year to Date Returns on Market Segments


For those who feel they may have “missed it”, the valuations and trailing returns for the non-S&P 500 segments appear anything but frothy. Should recession severity fears abate, the rise of the rest provides plenty of opportunity for capitulators to get involved.


The Dis-Inflation Motivation


Tuesday’s Consumer Price Index release buoyed the market and cemented the Fed. As a huge fan of symmetry, I thought I would share this chart:


A chart showing the consumer price index for all urban consumers since the 1970s


This chart chronicles the annual change for the Consumer Price Index over the last 50 years. Note that inflation never tends to hang around at highly elevated levels. On their own, higher prices crush demand which, in turn, leads to lower prices. Additionally, the Federal Reserve has a constitutional obligation to vigorously manage price levels. The combination of the two makes the persistently elevated inflation called for by the pessimists unlikely and historically unprecedented. Even in the 1970’s when the Fed had no experience managing money due to the recently terminated gold standard, peak inflation levels led to symmetrical troughs. The chart below chronicles the annual change in money supply (M2) going back to 1960:


Chart showing annual change in money supply since 1960


Note the roughly 10% annual growth for US money supply in the 1970’s. This monetary mismanagement led to higher-than-average inflation rates for a decade. Even still, while average levels were higher, the inflationary spikes seen in 1975 and 1979 corrected symmetrically. Fast forward to today. COVID stimulus policies led to an astounding 30% growth rate for US money supply. But unlike in the 1970’s, this policy profligacy rapidly reversed.


US money supply is now shrinking for the first time since the Great Depression. As a result, inflation has fallen even faster than it climbed. It took 14 months for this cycle’s inflation to climb from 4.1% to 9% and only 11 months for inflation to fall from 9% back to 4.1%. We will likely see 3% inflation in June, a level we haven’t seen since March of 2021. And just to further validate my simplistic “what goes up must come down” inflation hypothesis, markets agree, placing the 10 year forward inflation breakeven rate right at the Fed’s target of 2.2%:


A chart showing the 10 year breakeven inflation rate going back to 2004.


My point here is that inflation’s downward momentum has taken hold and inflation will continue to fall. It’s both science and policy at this point. And historically, periods of rapid disinflation have been followed by periods of robust investor returns:


A chart showing S&P Performance after large drops in CPI post WWII


Have a great weekend!


David S. Waddell  

CEO, Chief Investment Strategist




Sources:  FRED, YCharts, Bespoke
David Waddell
Author: CEO Chief Investment StrategistAfter graduating from the University of the South with a BA in Economics, David began his career with Charles Schwab & Co., Inc. in Phoenix, AZ. Having been recognized for his outstanding business development record, David was promoted to the San Francisco- based Institutional Strategic Accounts Team, which interfaced with the Big 5 accounting firms and Schwab’s largest customers. David left Schwab to continue his education at the graduate level in Boston. While earning his MBA degree with a concentration in finance and investments at the F.W. Olin School at Babson College, he was appointed by the college Trustees to manage a team of seven portfolio managers overseeing the student-managed portion of Babson’s endowment fund. David also founded the Babson Investment Management Association to assist undergraduate and graduate students with training and career path planning in the investment management field. As the firm’s Chief Investment Officer, David chairs the W&A investment committee and combines macro economic forecasting, macro market analysis and macro risk assessments to design portfolio strategies utilizing public market securities worldwide. A civic leader in Memphis, David currently acts as Chairman of Epicenter Memphis, and Co-Chair of the Memphis Chamber Chairman’s Circle while also serving as a board member for LaunchTN and the New Memphis Institute. David previously served as chairman for The Leadership Academy, the RISE Foundation, and the Economic Club of Memphis. He also chaired the capital campaign to build the “Live” stage at the Memphis Botanic Garden. David was a member of the 2004 Leadership Memphis class and has been recognized as one of Memphis’ “Top 40 under 40” by the Memphis Business Journal, and as a finalist for “Executive of the Year” in 2007. In addition to weekly columns in the Memphis Daily News and the Nashville Ledger, David has appeared in the Wall Street Journal, USA Today, Forbes, Business Week, Investment News, Institutional Investor News, The Tennessean and Memphis Business Journal. He has also made appearances on Fox Business News, Yahoo Finance, Bloomberg TV, CNBC, and CBS News and ABC News Channels. Read some of David's articles on his author page in Inside Memphis Business. David has two wonderful children, Easton and Saylor, an obedient Labradoodle named NASDAQ, and a devoted Goldendoodle named Ripley.


David S. Waddell


Chief Investment Strategist

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