Stock Market Surges on Cooling U.S. Inflation, But Don’t Get Complacent

U.S. stock markets ripped higher after U.S. inflationary data cooled in June fanning the flames of an interest rate cut in September. The core consumer price index (CPI), which excludes volatile food and energy costs, climbed 0.1% from May. That’s the smallest increase since August 2021. On an annual basis, core inflation was up 3.3%, also the slowest increase in more than three years.

Following the CPI report, Wall Street became increasingly optimistic that the U.S. Federal Reserve will announce its first rate cut during this cycle in September. On Wednesday, July 10, the day before the data was released, the implied odds of a September interest rate cut stood at 73% and just 52% a month ago. On Thursday, July 11, after the announcement, the odds of an interest rate cut soared to 89%.

Traders are also convinced the Fed will announce additional rate cuts in 2024, pricing in the probability of two or more at 89% and the odds of three or more cuts at 44%. Two 25-basis point rate cuts this year would take interest rates down from between 5.25% and 5.5% to between 4.75% and 5.0%.

The S&P 500, Nasdaq, DOW, and TSX Are All at Record Levels

Investors cheered the inflationary data, sending both the S&P 500 and Nasdaq into record territory.

The S&P 500 hit its 37th record closing high in 2024 on Wednesday, July 10. To put that number into perspective, the S&P 500 has hit a new record high every four days so far this year. And its valuation is getting hot. The trailing price-to-earnings (PE) ratio for the S&P 500 is at 28 times compared to a historical mean of 15 times.

The Dow last hit a new high in May and continues to trade near those levels. The Toronto Stock Exchange (TSX) also responded favourably to the news, and at 22,529, is within striking distance of its May 2024 high of 22,554.

Could the Stock Market Experience a Correction?

Despite the bullish sentiment on Wall Street and Bay Street, investors shouldn’t get complacent. There are numerous indicators that point to a stock market correction, which is defined as a pull-back of 10% from recent highs.

There is uncertainty around the U.S. presidential campaign, geopolitical tensions, and whether the U.S. will avoid a recession. We’re also entering earnings season. Stock valuations are at their highest level in almost three years, which means Wall Street earnings and guidance both need to be robust. If they fail to live up to expectations, they could get punished.

Despite a rising number of Wall Street analysts, including Morgan Stanley’s chief strategies Mike Wilson, warning U.S. stocks could experience a correction before the U.S. election, investors are unfazed.

In fact, the CBOE Volatility Index (VIX), which is more commonly referred to as Wall Street’s fear gauge, is hovering at its lowest level since before the 2020 health crisis. The VIX measures volatility in the stock market for the next 30 days. When Wall Street gets anxious and the S&P 500 and Nasdaq fall, the VIX goes up.

There are more than enough reasons for investors to be anxious. But they’re not. Going back to 1990, the average daily close for the VIX has been 19.49. But today, the 30-day rolling average for the VIX is just 12.73.

By all accounts, the third quarter could be choppy, a period that is, even at the best of times, seasonally turbulent. If second-quarter earnings disappoint, stocks could experience some kind of pullback in early August. And this could create opportunities for savvy investors.

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