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Jeremy Owens: Hello and welcome to On Watch by MarketWatch. I’m Jeremy Owens, a fresh inflation reading sent stock indexes to record highs last week, the Dow Jones Industrial Average even hit a brand new big round number 40,000. One problem, the inflation figures weren’t really that good. Prices continue to increase and squeeze Americans’ wallets. A recent Federal Reserve study found that nearly two thirds of Americans say inflation has damaged their financial situation. So today we’re going to take a deeper dive into the inflation numbers. Economics reporter, Jeffry Bartash, will tell us how Americans are actually experiencing what we hope to be the latter stage of an inflation shock.
Then we welcome our deep dive investing columnist, Philip van Doorn, to talk about what the market records really mean and what’s behind them. Plus we’ll take a quick look at the news stories we’re watching right now and how they will affect your wallet. First, let’s talk about inflation. When a fresh round of inflation data landed and Wall Street reacted by sending stocks to record highs, I was baffled. The numbers just weren’t that good. The Consumer Price Index for April showed that prices increased 3.4% from the year before, well higher than the Federal Reserve’s 2% target. This comes as we near the fourth anniversary of inflation beginning to shoot higher and the collective price increases of these years are destroying American’s finances.
And personally I don’t see it getting better in the months ahead. With summer travel season approaching, gas prices are going to spike. Things like rents and car insurance just aren’t cooling off. So what should we really take from this report and where is inflation headed? I called up MarketWatch Economics reporter, Jeffry Bartash, to get the real story. Well, Jeffry, we got CPI and the inflation was a tick lower than was expected, but we’re still experiencing strong inflation here. It seemed to me that the reaction from Wall Street was a little hot and heavy for a report that wasn’t that great. It certainly didn’t show inflation cooling a lot from where it’s been in the first quarter of the year already.
Jeffry Bartash: You’re correct. Wall Street views inflation very differently from ordinary Americans, and the truth is inflation is still going up more than twice the rate as it was before the pandemic. Inflation is running about 3.5% for the year, before the pandemic inflation was averaging about 1.5% a year. It was very, very low. It was so low most people didn’t even notice.
Jeremy Owens: Yeah. And what we’ve seen so far with inflation, it hasn’t really changed consumer behavior yet, and consumer spending is such huge part of the economy that that’s why the economy has kept rolling. Despite inflation hitting such high peaks and still being elevated right now, consumers have continued to spend, but we might be seeing a little bit of a change there and we saw Starbucks, McDonald’s, even Walmart earnings executives saying people are pulling back and they’re cutting out some of what they were spending on the past couple of years and looking to replace that spending or just get rid of that spending. Is there any sign of that so far and can we peg that to inflation at all?
Jeffry Bartash: There’s definitely some sign of that. The way you have to look at it is that people got a lot of stimulus money right after the pandemic. It’s pretty much all gone and after that, they dipped into their savings to support their current level of spending, but savings rates now fall into a pretty low level. So now people have to rely on their actual income, what they’re earning each week, taking home on their paychecks, so naturally they have to cut back to some extent. On the other hand, high inflation means they have to pay more than they used to, so they still have to spend a fair amount of money to get all the things they used to buy.
Jeremy Owens: Right. The core inputs, and we talked about this with Venessa Wong a couple of weeks ago when we talked about inflation, how it’s affecting the middle class. And a lot of that was about the core gains for things that you can’t avoid, you can’t change, and what we saw in this most recent inflation report were some of those inputs are getting more expensive. Gasoline was one that continues to gain and we’re heading into summer driving season, which means gas will be even more important and probably more expensive. Car insurance was one I know you called out as a gigantic gain in costs for consumers and housing. If you have a house and you drive to work, these are not things that are optional to you.
Jeffry Bartash: Now that’s why inflation is so punishing. You need some place to go to sleep and get up in the morning, you have to drive to work. The one good thing is food prices have leveled off after several years of really big increases, so people are starting to see a little relief, but the truth is prices went up so much in the last three or four years that whatever good things that happen in grocery stores are really hard to notice.
Jeremy Owens: Yeah. And I do the grocery shopping a lot of times for my family and while I have seen it level off lately, still I’m paying so much more than I was three or four years ago, but that could contribute to what we heard from some of the companies and earnings that as grocery prices flat-line a little bit, but other things get more expensive, you might just see people cutting out that Starbucks coffee a day, cutting out that McDonald’s burger on Fridays and just buying their stuff at the grocery store and taking it home.
Jeffry Bartash: People clearly have to make choices. They have to give some things up, they have to change their behavior. If you’re used to eating rib eye steak, you may have to settle more for ground beef. If you’re used to buying a new car every couple of years, you may have to put that off or buy a used car. You just can’t buy all the things you to with your current income. So you do have to change your behavior and that does frustrate a lot of people.
Jeremy Owens: Yeah. And there are definitely signs that while inflation has modulated a little bit, that we’ve at least stalled, if not come back down at all. There are some worrisome signs. I know you talked about the Producer Price Index, which we also got last week, which more reflects prices that companies are paying more for raw materials and things like that while the Consumer Price Index looks at what consumers are paying. And the Producer Price Index actually came in a tick higher than expected, which could suggest there are more price increases coming down the pike.
Jeffry Bartash: There’s definitely some price pressures in what I call the guts of the economy. A lot of the costs are raw materials for metals that are using machines and appliances and computers, gasoline. There’s various things like that the prices have gone up. Another issue is that the Panama Canal and the Suez Canal, two big major conduits of shipping around the world, they’re having trouble. Ships aren’t going through them as much, there was low water in Panama, there was a tax in the Red Sea, so shipping costs have gone up a lot and there’s not as much shipping available. So it’s costing companies a lot more to send their products from one country to another, and that ultimately means consumers have to pay more.
Jeremy Owens: Yeah. And I think everything we’ve seen so far in 2024 suggests that the punishing wave of inflation, while it has leveled off a bit, is still hitting every day Americans and beyond. So what are we going to take from this? Where are we moving forward with it and is there any hope for relief?
Jeffry Bartash: All signs do point to inflation starting to decelerate a little bit more as we get through the year companies, as you noted, they’re having trouble passing on price increases. Consumers are starting to resist. That’s why car prices are falling, with loans the cost of getting an auto loan’s so high, people are saying “To heck with that, I’m not going to buy a new car at that price.” So auto deals are cutting prices and offering more deals. We’re starting to see that throughout the economy, so that should bring prices down and if prices do slow a bit further, that allows the Federal Reserve to cut US interest rates. If the Fed cuts interest rates, that reduces mortgage costs and other borrowing costs, and that will also offer families some relief.
Jeremy Owens: Yeah, the reason for the excitement on Wall Street last week was thoughts that now the Fed would cut rates or at least wouldn’t increase them, but CPI isn’t even the Fed’s favorite inflation gauge. That’s actually PCE, which we will get next Friday. Talk to me a little bit about the differences there and why PCE could be a more well-rounded gauge of how prices are acting in America.
Jeffry Bartash: Well, I know this can be alphabet soup for a lot of viewers and listeners, but the CPI is a longstanding inflation measure used by the United States and notably Social Security recipients, anyone that gets Social Security, every year your adjustment in how much you get from the government is tied to how much the Consumer Price Index goes up every month. And the union contracts are also often tied to the CPI. So the CPI has been the better known and long-standing measure of inflation for the United States. Now there’s this new measure you mentioned, it’s called PCE. It’s what the Fed prefers as a more accurate gauge of real inflation. The big difference is what the PCE does is it takes into account the changes people make in their behavior. If you go to a grocery store and the brand name costs a dollar more than this generic brand, then people start using the generic brand.
So the PCE captures how people change their behavior by buying cheaper items instead of more expensive ones. The one other big thing is that the Consumer Price Index probably puts too much weight on rent and housing. It is the single biggest expense for most people, but it probably exaggerates what they pay for shelter. So the PCE doesn’t give as much weight to housing and therefore it’s running a bit lower than the CPI. The CPI is running at about 3.5% year-over-year. That’s still well above the Federal Reserve’s goal. The Fed wants to get inflation down to 2% a year or less just like it was before the pandemic.
Jeremy Owens: It seems like PCE would be a better gauge right now to track what’s happening. As we just talked about with Starbucks, McDonald’s and other CEOs saying “We’re seeing consumers back off of paying for prepared goods and maybe buying more packaged goods and making food at home and things like that.” PCE would track that a little bit more and we would probably be able to see that a little bit better in those numbers.
Jeffry Bartash: We certainly would, although the two inflation barometers tend to track very closely over time, and if they show a big divergence is very unusual, the Fed can’t just go by one and ignore the other. The Fed wants to see inflation coming down across the economy through the various inflation and price gauges that it monitors. It also wants to hear it from businesses that businesses are reducing prices and until the Fed sees evidence that inflation across the entire economy is coming down, they’re not going to move to cut interest rates.
Jeremy Owens: Even if inflation slows though, Jeffry, we’re still going to be dealing with these higher prices. Americans are still going to be dealing with this and we are going to see increases even if they don’t show up in those inflation numbers like the gas prices going up this summer.
Jeffry Bartash: The Federal Reserve takes that into account, but whatever the case, your point remains. People are still facing higher and rising costs and the truth is inflation goes up, it almost never goes down. It’s gone down in one year in the last 50 years. So even if inflation slows and gets back to what we consider normal, people aren’t going to get any financial relief for several years or longer. What ultimately has to happen is their wages, their paychecks have to grow faster than inflation three years, five years for another seven years until they’re back to where they were five years ago.
Jeremy Owens: Right. We want to watch the job reports for that wage growth, that will be huge wage growth to continue to outpace inflation over the next few years. Jeffry, thank you so much for joining us and we’ll talk to you again about inflation and everything else. We’re going to take a quick break. Coming up Dow 40,000, stay with us.
Welcome back to On Watch by Market Watch. Before the break, we talked with Jeffry Bartash about the inflation report. Now let’s discuss the market’s reaction to that report. Whenever I’m confused about what is happening in the market and how a typical American should process it, I talked to Philip van Doorn. In this case, Phil and I found agreement that the market being at all time highs is not strange, but the impetus for last week’s spike is. If you want to be optimistic about the markets right now, the economy and inflation are not the reason, corporate earnings are. So here’s Phil to discuss what long-term investors should truly be looking at. Well, Phil, last week we got an inflation metric that was not super great, but the market loved it. It sent the Dow to 40,000 for the first time. There’s a lot of excitement. They made the hats, all that kind of stuff. So tell me, what did you take from last week’s action and from finally hitting Dow 40,000?
Philip van Doorn: It seemed that the narrative changed a little bit where some investors no longer feared that interest rates would continue to increase. So many people bought into this narrative that the Federal Reserve would lower interest rates several times during 2024, but then we kept getting disappointing inflation numbers in the government reports. So anything leading to investors believing that interest rates will rise is going to push the stock market down and vice versa. So the narrative changed a little bit, and I would also caution everyone not to read too much into this stuff. If you are a long-term investor, you should not be focused on Federal Reserve policy or the daily pronouncements from the various regional Federal Reserve Bank presidents. A lot of this is nonsense speculation and it harms long-term investors. Of course, interest rates will decline eventually because lower interest rates means it costs less for the government to borrow and the government needs to borrow to provide all the social services that help members of the government to be reelected.
Jeremy Owens: Meanwhile, we are getting strong earnings from companies. To me that is the impetus for stronger markets because we are actually seeing that the price to earnings ratios are staying strong because we’re continuing to see corporate profits and corporate revenues go higher.
Philip van Doorn: Well, there you go. The increase in earnings estimates, which is driven by the quarterly earnings reports continues to support these stock valuations. The US economy is expanding at a decent pace. Unemployment is low, profits are increasing, individual people are suffering on the expense side. We’re all feeling this personally as we are affected by different portions of that inflation figure, but the equity market loves it.
Jeremy Owens: For sure. And you just did a recent screen for us on the earnings season winners so far. Who has really impressed you so far in terms of both growth in revenue and in profit?
Philip van Doorn: Well, it’s a rather elaborate screen, but what we did was we looked at profit margins. We don’t just look at earnings per share because that can be distorted. An extraordinary legal cost, a write-down of a non-cash item such as goodwill, that sort of thing. So we look at profit margins, we look at gross profit margins, which really reflect pricing power and then operating margins, which also incorporate overhead. If we boil down the data and isolate companies that have improved their quarterly operating margins and gross margins from a year earlier, we have companies that are showing pricing power if we sort the list by the ones whose sales have increased the most.
And what impresses me the most on this list is number 25, which is Microsoft. This company represents 7% of the S&P 500 index. Its quarterly sales rose 17% from a year earlier while its gross income margin expanded and its operating margin expanded from a year earlier. I think that’s incredible. This is a company whose market valuation is 3.1 trillion, 7% of an S&P 500 index fund, the type of fund that so many of us are invested in. So this means something to every investor in the US stock market and it is an incredible performance for such a large company.
Jeremy Owens: It is, and we’ve talked about how much of the S&P 500 now is driven just by Big Tech, and I noticed three members of Big Tech are on that list for you. That was Alphabet, Meta and Microsoft along with some other tech names like Netflix was on that list. And I think that’s a big point to make about the market hitting new record highs is when the largest companies and the most dominant companies in that index are showing those types of gains.
Philip van Doorn: Yeah. And consider Netflix, the changes that they’ve made, the operating improvements, they handled their clampdown on password sharing in a way that was actually pretty friendly to customers. They introduced new family pricing plans through which you could add people to your account for a small fee. So they discouraged password sharing, but they enabled us to share our Netflix account with more people for only a little bit extra money. So I thought that this was a beautiful thing. It shows you the proper way to handle customer service while still being on the cutting edge and dominating this industry.
Jeremy Owens: Right. And they brought in advertising so they have a second route to revenue and offered consumers a lower priced subscription that would include advertising, and they’re actually making more money per consumer on those deals, on those subscriptions, even while charging less because they’re getting the advertising money on top of it.
Philip van Doorn: Yeah, I’m only looking at the gross number here, but the sales are up 18% year over year while both margins have improved. So it’s incredible.
Jeremy Owens: Yeah. And margins are really increasing across the big tech companies right now after the big layoffs. And the question is what they’re doing with that money, in the case of Meta and Alphabet, they’re going to ship it right back to Wall Street. These companies established dividends, which I never thought we’d see from them, or at least not in this era. It’s not something that Silicon Valley companies have typically done this early in their lifetimes, but it tells me that maybe they’re optimizing more for profit now instead of revenue.
Philip van Doorn: Well, and eventually you can’t grow revenue that quickly, but you could still, as you said, make a lot of money for investors. Consider Apple, that’s a slow grower. You can’t move the needle that much on the sales side, but Apple has been reducing its share count so steadily that this has improved the bottom line and helped the stock perform incredibly well over the last 10 years. Looking at Apple, their share count is down 37% in 10 years. The stock has returned 872% last time I looked, that data’s a week stale, but it’s one of the most incredible companies for lowering the share count. Some buybacks don’t lower the share count at all.
Jeremy Owens: Especially in Silicon Valley where so much stock is provided as payment to employees. Yeah.
Philip van Doorn: So the company buys back less shares than they’ve handed to their executives, and then they call it a return of capital to investors. It’s not a return of capital to investors. In fact, it’s doling capital to people who want to sell the shares. Then at the same time, they’re touting it even though their share count is going up, which means their loyal shareholders’ ownership positions are being diluted, shame on them.
Jeremy Owens: Yeah. And we saw that with Apple $110 billion stock buyback plan they announced in this earnings season, and that number just blew me away. But all of the numbers with Apple are so huge, but Apple did not show up on your screen because it is not increasing those. It has struggled to increase sales and profits by the same amount as some of its competitors and big tech especially.
Philip van Doorn: But it shows up on another screen. They’ve bought back $645 billion worth of shares over the last 10 years while decreasing the share count by 37%. So Apple’s doing something different. In fact, Apple’s more along the lines of what you’re talking about, it’s becoming something of a value stock, but not because of the dividend, because of the buybacks, effective buybacks.
Jeremy Owens: It seems like to me these big tech companies are now optimizing for profit all of a sudden instead of revenue growth. Phil, I’d say the real reason to be excited about stocks right now, the real reason they’re at records is not the economy, it’s not inflation, it’s none of those things. It really is just corporate earnings, especially from Big Tech. That’s really what’s driving this market to records.
Philip van Doorn: I would add that stock market records mean nothing. A healthy market is always at a record.
Jeremy Owens: Right. And we’ve got a few more records maybe in the future, but should people be concerned that there is a pullback in the future, Phil?
Philip van Doorn: There will always be a pullback. I’ve been in this business since 2007 and seen alarming warnings of a stock market crash every single day. But if you’re a long-term investor and you’re making regular contributions to a retirement account that’s broadly spread through the stock market, it’s good for the stock market to crash once in a while because you pay lower prices. It enhances your long-term return if the stock market pulls back and then recovers, which it has always done.
Jeremy Owens: Phil, we’ve talked a lot about tech so far. What other sectors are you looking at or interested in right now?
Philip van Doorn: I still believe that the US energy sector is something fascinating to keep an eye on. Since the US players are now so well run, since they are avoiding the risks that they took through the middle of 2014 before the oil price crashed, I think that that’s a wonderful sector to invest in.
Jeremy Owens: Phil, we’ll continue to talk to you about these things. Heck, we might even be back for Dow 50K at some point.
Philip van Doorn: We will certainly get there and we could celebrate together.
Jeremy Owens: I look forward to it. Phil, I might even buy the hat.
Philip van Doorn: Thanks, Jeremy.
Jeremy Owens: Thank you. Before we go, it’s time for what we are watching. A look at the news you need to know for the rest of the week and beyond. This week, we received more signals that the economy is on a bumpy road in 2024, the minutes of the Federal Reserve’s most recent meeting showed Fed officials indicating a willingness to raise interest rates again if inflation didn’t cool off. That meeting happened before the most recent inflation reading, but the minutes don’t necessarily line up with Wall Street’s expectations for two rate cuts this year, and big companies continued to feed into doubts about consumer spending as well. Target’s quarterly results missed expectations due to weaker sales of discretionary items. The retailer expects to cut prices on thousands of items heading into the Memorial Day holiday weekend, the kind of move that could help ease inflationary pressures.
Nvidia continues to blow away expectations thanks to the AI boom, the chip-maker reported strong results and forecast even better returns on Wednesday, sending the stock toward fresh highs. CEO Jensen Huang is looking to share the wealth of the past year’s huge profits too. Nvidia plans to increase its dividend by 150%. The company will also split its stock as the share price nears $1,000 with investors receiving 10 shares for every one they currently own. That should put Nvidia’s shares closer to $100 a piece depending on what happens in the next two weeks before the split takes effect. Moving forward, a new rule will go into effect Tuesday that will affect almost every stock bond and ETF trade in US markets. The new rule establishes a T plus one settlement cycle. That means both the buyer and seller of stocks and bonds will have just one day to finalize a transaction. That’s down from the current two-day T plus two rule. Investors might not notice the transition to T plus one, but they still stand to benefit from it. Financial industry groups say the new rules will help reduce risk and increase efficiency.
And that’s it for this episode, thanks to Jeffry Bartash and Philip van Doorn. To keep following the latest on inflation in the markets, head to MarketWatch.com. You can subscribe to the show wherever you get your podcasts, and please do. If you like what you heard, please leave us a rating or review. It really helps others discover the show and let us know what you want to hear from us. You can reach us at On Watch at MarketWatch.com. The show is hosted by me, Jeremy Owens, and produced by Mette Lutzhoft and Jackson Cantrell. Isaac Gaines mixed this episode. Melissa Haggerty is the executive producer. We’ll be back next week with a new episode, and until then we’ll be watching.
