The stock and bond markets knew inflation was coming. This week's 6.2 percent jump in the Consumer Price Index drove home the fact that inflation has become a fact of economic life, at least for the near future.

 

The jury is still out on whether inflation will prove to be "transitory" as the Federal Reserve Bank argues and as some economists believe. Others fear that we could be on the verge of something a little more serious. The fear is that the Fed might be forced to raise interest rates if that were the case.

 

The Producer Price Index (PPI) and the Consumer Price Index (CPI) both came in a little warmer than forecasted on a year-over-year basis, but not as high as some expected. And yet the U.S. dollar spiked to new highs, the yield on the U.S. Treasury rose by more than 10 basis points, gold and silver jumped, and stocks dropped.

 

The culprit behind the ongoing pressure on the inflation rate, as readers know, is the heightened consumer demand caused by the reopening of the economy and the supply chain issues that do not seem to be easing. The pandemic can be blamed for both conditions.

 

For me, the markets were so over-extended and in need of a pullback that traders were just looking for a reason to take down the averages. As you may recall, I had been expecting a minor bout of profit-taking, no more than 3 percent or so, in the markets. This week, the S&P 500 Index lost almost 2 percent, while some other indexes like the small-cap, Russell 2000 Index and some technology areas were down more than 3 percent before rebounding.

 

Between the good news on the passage of the $1 trillion infrastructure bi-partisan spending program (which now awaits signing by President Biden) and the climbing rate of inflation, the market winners have been mostly in sectors that benefit from construction and inflation. Mines and metals, gold and silver, basic materials, lithium, uranium and rare earth plays have climbed during the past few days. These sectors have played a back seat to large-cap technology stocks over the last two months. We have seen this kind of rotation many times in the past. Once prices have been bid up to unreasonable levels, short-term traders will switch their focus back to technology, or reopening plays. What is important to understand is that the overall markets tend to rise, or at worse move sideways, as some sectors that are out of favor are simply replaced by those in favor. 

 

Consolidation is healthy for the markets. A period of digesting gains, possibly over the next few days, would do wonders for reducing the overbought conditions that presently plague many stocks and sectors. Investors should keep their eyes on the U.S. dollar, which appears to want to climb even higher. If it does, it could squash the present rise in commodities.

 

Gold is another asset I am tracking closely. It has been one of the world's worst performing assets in 2021. If inflation fears continue to worry investors, there is a possibility that gold may reemerge in its traditional role as an inflation hedge.

 

Last, but not least is the cannabis space. A bill introduced by Nancy Mace, a Republican House member from South Carolina, to decriminalize and regulate what is now a federally illegal substance, sent pot stocks higher. This could be a huge boost for the U.S. cannabis industry. Stock prices in this industry has languished all year, despite improving profitability in many cases.    

 

The Federal Reserve Bank signaled an all-clear for the financial markets this week. The tapering they promised will begin on schedule, but Fed Chairperson Jerome Powell has no plans to raise interest rates until at least some time next year.

 

The announcement was met with relief. Investors reacted by catapulting the stock market to yet another higher high. Bond traders were somewhat mollified, as well as seen by the lack of movement in interest rates. If anything, Chair Powell was a bit more dovish than investors expected.

 

He surprised markets by reducing the size of the monthly taper, which will begin later this month. At present, the U.S. Central Bank is buying $120 billion a month in assets. Investors were expecting a $20 billion monthly reduction in purchases, but the Fed decided to reduce those purchases by only $15 billion a month.

 

It appears that the rate of inflation is still not serious enough for the Federal Reserve to move forward their expectations on raising interest rates. Next summer is the earliest Powell sees a need to raise interest rates. However, he did admit that he expects the conditions that are pushing inflation higher could persist well into next year. 

 

His stance is similar to the position already taken by the European Central Bank (ECB). The ECB expects to continue its easy money policies into next year. But while most of the developed world is applying the momentary brakes ever so gradually, many emerging market countries are already raising interest rates to head off rising inflation in their economies. Chile, Russia, and Brazil, for example, have hiked interest rates recently. Of the 38 central banks followed by the Bank for International Settlements, 13 have raised a key interest rate at least once this year.

 

Investors are paying close attention to the stalled situation surrounding the two large Biden infrastructure bills after the resounding thrashing the Democrats suffered this week in various elections. Voters seem to be increasingly unhappy with what they perceive as their "do nothing." President Biden's approval ratings are dismal, and time is running out to reverse the situation before the mid-term elections.

 

It remains to be seen whether this week's election results will spur this fractured party to come together and start legislating or sink further into disarray. The House is expected to vote on at least one if not both bills on Friday, Nov. 5.

 

There is a lot riding on the outcome for the economy and the markets. And while the price tag for both bills is high, as a percentage of GDP, in reality the expenditures are a drop in the bucket when compared to what other countries are spending on their own infrastructure plans. Is it any wonder that China sees us as no more than a "paper tiger," whose politicians lack the will to compete in the areas that really matter?

 

Earnings season is winding down, but once again the results defied even the most bullish of expectations. That bodes well for stocks. More and more sectors are participating in the upturn and there doesn't seem to be many storm clouds on the horizon until we head into December, if then. This week's decline in oil may also act as a tailwind for stocks. Higher energy prices have been leading inflation higher for the last few months. If oil pulls back from here, or just remains in a trading range, equities could get a boost from that as well.

 

To me, however, the most important event of the week was drug company Pfizer's announcement that Paxlovid, a COVID-19 pill, reduced the risk of hospitalization or death by 80 percent in a clinical trial that tested the drug in adults with the disease who were also in high-risk health groups. 

 

Pfizer CEO and Chairman, Albert Bourla, said, "These data suggest that our oral antiviral candidate, if approved or authorized by regulatory authorities, has the potential to save patients' lives, reduce the severity of COVID-19 infections, and eliminate nine out of 10 hospitalizations." To me, this pill could be a game changer for the economy and for people all over the world. It is possible that we could see the coronavirus battle won by sometime next year.

 

I have been expecting a shallow pullback in the markets for the past two weeks. Instead, stocks have just climbed higher and higher. They are extended, but history says they can get even more so. As such, I am not holding my breath, nor waiting around for it. Whatever pullback does occur should be bought.

 

Third-quarter earnings have cheered investors, sending markets to new highs. The bullish wave of buying was so strong that investors ignored the disappointing third quarter read on the nation's Gross Domestic Product (GDP).

 

Economists were looking for the economy to grow by 2.6 percent, but instead, GDP gained a mere 2 percent, which was the slowest rate in over a year. Economic activity was damaged by the Delta variant as well as continuing supply-side constraints. The market's reaction indicates that investors are looking through the weak number and expecting the economy to continue to grow.

 

It seems to be a question of demand versus supply. Yes, the economy slowed, but it wasn't because demand is slowing. It was simply a matter of supply chain bottlenecks that are forcing pent-up demand further into the future.

 

As we close out this week of earnings the "beat" rate of corporations is more than 80 percent. Most of the big mega-cap technology companies (with some exceptions) have once again delivered good results, which has kept the markets buoyed. Managements continue to complain about supply constraints and higher prices, which are compressing profit margins in some sectors, but not enough to really hurt overall results.

 

As for the Fed, next week on Nov. 3, the long-awaited FOMC meeting will occur and with it the expected start date of the tapering of asset purchases. It seems to me that the Federal Reserve Bank and its Chairman Jerome Powell have done everything in their power to prepare the markets for the onset of tapering. It remains to be seen how the markets will react to the actual implementation of tapering. We could see some nervousness leading up to the meeting.

 

But the new topic of conversation — a rise in interest rates. When will the Fed start raising interest rates from the near-zero levels at present? Some traders believe that interest rates will be hiked faster than most investors are expecting. Rising inflation is the impetus behind that conviction. Persistent and accelerating inflation is the biggest risk to the market right now, in my opinion. If the inflation rate continues to gain, investors would worry that the Fed might be forced to raise interest rates by as many as two hikes next year, and three in 2023. That would most likely create severe negative repercussions for the stock market. 

 

Democrats are struggling to compromise on some version of an infrastructure bill with President Joe Biden urging House Democrats to accept a scaled-down version of his Build Back Better proposal. This week, the package would amount to $1.75 trillion versus the $3.5 trillion he originally requested. Progressive Democrats would have to agree to jettison pet projects such as paid family leave and expanded Medicare coverage of vision and dental for elders. Both of which were popular with voters and a priority for several woman lawmakers. A 15 percent minimum corporate tax, a 50 percent minimum tax on foreign profits of U.S. corporations, tax hikes on the highest income Americans, and possibly a surtax on multimillionaires and billionaires are still on the revenue raiser list.   

 

As for stocks, most markets are extended. That may mean we see some profit-taking during the next week. I am not looking for anything serious, maybe a 2-3 percent spate of selling (at most) that might take us into next Wednesday's FOMC meeting on November 3, 2021.

 

My own bet is that investors will like what Chair Powell will say, and if so, we could see another leg higher for the markets. If Congress does come through with an infrastructure compromise bill, the markets would get a lift. As such, I would use any dip to add to equities. After that, I think we have smooth sailing into the end of November.

 

The S&P 500 Index and the Dow have managed to pierce overhead resistance. This week, both hit record highs. It seems only a matter of time before the NASDAQ will follow but probably not before we have a minor pullback.

 

As of Friday morning, equities have managed to string together seven days of continuous gains. Do I hear eight? That is a tall order, because stocks are now overextended by just about every measure I follow. We could do with a minor pullback, or pause, before extending this rally higher.

 

Credit for the gains can be attributed to third quarter earnings results. The results have been much better than expected. The big fear was that supply chain disruptions and rising prices would crater corporate results. Not happening.

 

Company managements are acknowledging that disruptions are hurting results, but despite them, business is still growing. And at the same time, companies have been able (for the most part) to pass on rising prices to consumers and getting little-to-no pushback from the public thus far. Guidance is good, and if this goldilocks kind of environment lasts, it's up, up and away.

 

And while fear of inflation does not seem to phase equity investors, it is another story over in the bond market. The benchmark, U.S. Ten-Year bond yield is climbing, reaching its highest level in months at 1.67 percent. The high this year so far has been about 1.76 percent and the bond vigilantes seem determined to keep selling bonds until we hit that level. The last time that occurred equities did fall by almost 5 percent. The question is what will happen this time around.

 

In the meantime, both yields and stock prices are heading in the same direction, which has been great if you own financials, but not so good if you are overweight technology. It is one reason why NASDAQ has yet to recover all their losses from the September-October declines.

 

The Democrats continue to behave like their own worst enemies, failing day after day to come to a compromise that would move President Biden's "Build Back Better" legislation forward. As it is, the proposed $3.5 trillion plan has been whittled down to somewhere between $1-2 trillion. It appears that the corporate tax hike has also fallen by the wayside, although individual taxes are still on the table. As I have counseled, readers should expect more delay and more compromise before some watered-down plan will finally be passed, hopefully this year.

 

My own explanation, however, on why investors and the markets have become more optimistic over the last two weeks is the pandemic. Every week over the last 18 months, I have been writing that the Coronavirus was the over-riding issue for the economy and the stock market. And yet, I realized over the weekend that I have not mentioned the Coronavirus once in the last two weeks. Does that mean the pandemic is over? No, not by a long shot, but I think we are over the hump barring some new and vaccine-resistant variant.

 

Thanks to the government's vaccination and booster efforts, we may be turning the corner, which could usher in a further spurt of growth in the economy. As such, I believe we could see further gains in the stock market as the year progresses. In the short, short-term, I am expecting a pullback in the markets as early as next week. On the S&P 500 Index I could see risk down to 4,450 or so, but 50 points at a minimum. That would be a dip to buy.

 

Bill Schmick is the founding partner of Onota Partners, Inc., in the Berkshires. His forecasts and opinions are purely his own and do not necessarily represent the views of Onota Partners Inc. (OPI). None of his commentary is or should be considered investment advice. Direct your inquiries to Bill at 1-413-347-2401 or email him at bill@schmicksretiredinvestor.com.

It appears that we have established a range in the stock market over the last few weeks. The bears have not seen their worst predictions come true. My hope is that we leave this month where we entered it.

 

September 2021 was treacherous. Bears were calling for a 10 percent correction at a minimum. Bulls, already on the back foot after witnessing a 5 percent pullback in the indexes, insisted we had seen the lows. Since then, we had been bouncing back and forth in a range. This week, however, appears to be a game changer.

 

We have not re-tested the lows on the S&P 500 Index, which we hit on Oct. 1, 2021, at 4,288 (intraday), nor have we come close to the highs made on September 24, 2021, at 4,555. But we did regain the 50-day moving average (DMA), which is a good sign for the bulls.

 

Stocks daily have been opening higher in the mornings but giving back their gains and closing lower by the end of the day. Bulls argue that the markets are simply consolidating after more than a year of fantastic gains with few corrections. The bulls could be right.

 

On the other hand, the bears point to the imminent removal of the Fed's punch bowl in November 2021 (the beginning of asset purchases tapering) as a reason to remain cautious into that event. If we then throw in all the other worries that are creating angst among investors — supply chain issues, inflation, political chaos in Washington — the October volatility we have been experiencing thus far should come as no surprise.

 

If I could, I would call off this present stalemate and declare both sides a winner. Afterall, we did suffer a 5-plus percent selloff, which should satisfy the bears' need to see some "blood in the streets." The bulls should be thankful that the downside has been contained.

 

Readers who follow my columns regularly know that I highlighted the seriousness of the supply chain shortages months ago. Today, that's all you read about in most media outlets. I am not crowing about my forecasts, rather, I am reminding investors that this is old news and has already been discounted in the price of stocks, in my opinion, so ignore the headlines.

 

The only question to ask is how long this global condition will persist, and what that may do to the inflation rate. My own belief is that it won't be resolved until well into next year.  Even then, some shortages will persist, but it is impossible to predict which ones will remain. Clearly, this problem will continue to act as a weight to further global growth, but it won't kill it, as some are predicting. As for its inflationary impact, it adds another variable to the factors that are already contributing to a rate of inflation that has surprised everyone, including the Federal Reserve Bank.

 

One reason the markets rallied this week above that all-important 50-DMA was a less than anticipated rise in both the Consumer Price Index (5.4 percent year-over-year), as well as the Producer Price Index (8.6 percent year-over-year) for September 2021. Prices paid to U.S. producers increased in September at the slowest pace of the year, thanks to cooling costs of services. Final PPI demand increased just 0.5 percent from the prior month.

 

Since PPI is one of the main variables that the Fed studies when making monetary decisions (like when to raise interest rates), markets rose over 1.5 percent on Thursday and added to those gains on Friday. But one set of monthly numbers does not tell the whole story. I expect further increases in the inflation rate before the pressure subsides.

 

However, I am hopeful that we enter a more positive period for stocks in the last two months of the 2021 led by cyclical sectors of the market. I began the year by recommending commodities, industrials, financials and some technology. That advice remains viable. We are halfway through October and the markets are already shaking off their worries. Let's keep our fingers crossed.

 

Bill Schmick is the founding partner of Onota Partners, Inc., in the Berkshires. His forecasts and opinions are purely his own and do not necessarily represent the views of Onota Partners Inc. (OPI). None of his commentary is or should be considered investment advice. Direct your inquiries to Bill at 1-413-347-2401 or email him at bill@schmicksretiredinvestor.com.