The stock market has rebounded in May, nearing record territory after April’s pullback. The upcoming April inflation data, due Wednesday, is seen as a potential catalyst for either new highs or another decline. Tom Essaye, founder of Sevens Report Research, analyzed the potential “good, bad, and ugly” outcomes for the April consumer-price index (CPI) reading. Rates traders started 2024 expecting the Federal Reserve to cut rates six or more times by year-end. However, hotter-than-expected CPI reports have reduced these expectations to about two cuts this year. Despite April’s dip, stocks recovered after Fed Chair Jerome Powell suggested on May 1 that a rate hike wasn’t imminent. The S&P 500 is up over 9% year-to-date, close to its record high. The Dow Jones is less than 600 points from the 40,000 mark, and the Nasdaq has risen over 9% in 2024. The April CPI reading is crucial. Economists forecast a 0.4% monthly rise, slowing the year-over-year rate to 3.4% from 3.5% in March. Core CPI, excluding food and energy, is expected to rise by 0.3% monthly and slow to 3.6% annually from 3.8%. Essaye identifies three scenarios: Ugly: A core reading of 3.9% or higher would likely trigger a “solid selloff,” reinforcing the idea that inflation is persistent and rates will stay high. This could erase recent gains, with the S&P 500 potentially dropping 1% or more, all sectors declining, and the 10-year Treasury yield rising by 10-15 basis points. The U.S. Dollar Index might exceed 106. Not So Great: A core reading of 3.7%-3.8% would probably cause stocks to fall and Treasury yields to rise. This would indicate persistent price pressures, leading to a “mild selloff,” with tech and cyclical stocks outperforming defensive plays. Good: A core reading at or below 3.6% would likely bring relief, suggesting a decline in core inflation. This could push stocks to new highs, led by sectors outside the “supercap” tech names. Treasury yields might fall sharply, and the dollar index could weaken as investors anticipate more rate cuts in 2024.

As stocks resume their upward climb towards record highs following a brief April downturn, a sense of complacency is returning to options markets. This shift is evident in the decreasing prices of hedges designed to protect investors’ portfolios against potential market pullbacks or crashes. Rocky Fishman, founder of Asym 500, a firm specializing in options market data and analytics, notes a substantial decrease in the cost of these contracts since the beginning of May. The rebound in stock prices has led to a significant narrowing of the spread between the Cboe Volatility Index (VIX) and actual stock volatility, reaching one of its lowest levels in years. The VIX, often referred to as the “fear gauge,” has fallen to its lowest level since January, signaling reduced expectations for market volatility. This decline in volatility has made crash insurance, in the form of VIX calls, extremely affordable. For example, VIX call options with a strike price of 25 expiring in around 40 days are currently trading at just 30 cents per contract, a considerable decrease from their cost a year ago. Furthermore, protection against even a modest market downturn has become cheaper, as indicated by the reversal of the S&P 500 index skew. This shift suggests that traders are once again preferring bullish calls over bearish puts. The accessibility of VIX calls and index puts presents an opportunity for investors seeking to take positions, such as anticipating higher-than-expected consumer price index reports. However, any signs that the slowdown in inflation could be more enduring might prompt a reevaluation of the timing of Federal Reserve interest rate cuts. Despite a brief setback in April, both the S&P 500 and the Dow Jones Industrial Average have largely recovered, with the S&P 500 securing its third consecutive weekly gain and the Dow Jones rising for an eighth straight session. However, the Nasdaq Composite experienced a slight decline amidst these movements.

The Threat Posed by Surging Profit Margins to Stocks The upward trajectory of corporate profit margins, while currently advantageous, cannot be sustained indefinitely, potentially signaling trouble for the stock market. Recent data from S&P Dow Jones Indices reveals that the S&P 500’s operating profit margin for the first quarter of 2024 hit 11.76%, with the trailing four-quarter margin reaching 11.44%, surpassing figures from 2023 and 2022. These figures mark a return of profit margins to their long-term trendline after fluctuations associated with the Covid-19 economic downturn and subsequent fiscal stimuli. Analysts project further margin growth, with estimates indicating margins above 12% for 2024. This expansion is crucial for the current valuation of the stock market; if margins were at 1990s levels, the S&P 500 would be valued significantly lower. Economists are skeptical about the sustainability of margin growth, particularly given the decline in labor’s share of income over the past three decades. While some anticipate ongoing margin expansion, others, such as Rob Arnott of Research Affiliates, predict a return to historical norms. Such a shift could dampen future market returns. Even if margins stabilize, prospects for robust market performance are limited. With high P/E ratios and sluggish sales growth, investors may face below-average returns over the next decade, especially if economic growth continues to decelerate.