The headlines remained quite dour last week, and hopes of a quick resolution in the Middle East continue to dwindle. Crude oil up in the mid-to-upper $90s also has many on edge, with concerns about how long it might stay there. Higher inflation could be coming as well, which means it could be harder for the Federal Reserve Bank (Fed) to cut interest rates later this year.
The S&P 500 was lower for a fourth week in a row and it is now officially in a mild correction of more than 5%. Did you know that from late October until November 20, the S&P 500 fell 5.1%? We could ask many investors, and there’s a good chance not many could remember why this happened. Clearly the headlines have been much worse this time, but one could argue this shows an incredibly resilient market—or it simply highlights that volatility is the toll we pay to invest.
Volatility Happens
“The stock market is fun, but sometimes very painful.” — Regis Philbin
Even the best years have some bad days. Last year is a perfect example, as we had a near bear market (down close to 20%) after Liberation Day, yet stocks soared back to new highs and it was another good year for the bulls.
We all want to gain 20% a year forever, but that isn’t possible, and in order to see the solid returns that stocks can provide in the long run, you have to be able to withstand the inevitable volatility and bad times. Or as Regis put it, “The stock market is fun, but sometimes very painful.”
During times like this, we like to share this chart. On average, you get one 10% correction and more than three 5% mild corrections a year. Given we just saw our first mild correction this year, it’s good to remember that it is perfectly normal to see some market jitters and volatility, as it happens most years.
Earning Drive Long-Term Stocks Gains
We get it, the headlines are quite bad and confusion reigns. But as of now, we do not see a pending recession for the US, and when we look up at the end of 2026, it should be another solid year for investors.
One bit of good news is earnings continue to soar, with various groups showing no major stress from a change in consumer or business demand yet. This week, we saw various airlines report solid guidance, and AI demand has shown no slowdown either. In the end, S&P 500 forward 12-month earnings estimates hit another new high last week. There isn’t much of a better indicator for what stocks will do than earnings, and this should be comforting for investors. Even though the headlines are scary, it doesn’t mean we should ignore good news when it’s there.
The Negative Sentiment Is Building, and That’s a Good Thing
Yes, the S&P 500 is only down a little over 5%, but if you saw some of the sentiment indicators, you would think it’s much worse. That’s a good thing. Often, the more extreme the emotion, the greater the benefit of being contrarian. That doesn’t mean we’re calling a bottom. But more fear means more bad news is likely already priced into the market, which makes an upside surprise more likely. As General George Patton said, if everyone is thinking alike, someone isn’t thinking.
Here are a few sentiment indicators highlighting the fear we’re seeing.
1. The CNN Fear & Greed Index is firmly in extreme fear.
2. The Economist just had this doozy of a magazine cover. We don’t blindly invest in magazine covers, but over-the-top covers like this historically can be a contrarian signal, especially when you see red arrows pointing down.
3. The American Association of Individual Investors (AAII) Sentiment Poll has seen the number of bulls decline for a record seven weeks in a row and the number of bears above 50% for the first time since last May.
4. The Bank of American Global Fund Manager Survey saw a six-month low in investor sentiment.
5. Last Thursday saw continued worries about private credit and the potential fallout. As a result, Bank of America data showed record outflows from financial funds.
A lot of measures of worry have spiked recently, and some indicators have even hit extremes. It doesn’t mean there won’t be more challenges ahead and there are certainly no guarantees. But market history has strongly suggested that the worse sentiment gets, the more the odds are moving in patient investors’ favor.
The Fed Seems Befuddled as Rates Stay Unchanged
Life is transitory, and so are inflation shocks … on a long enough timeline.
So, let’s talk Fed. The Federal Reserve held rates steady in the 3.50% to 3.75% range at their March meeting, as expected. But all eyes were on the Fed’s updated Summary of Economic Projections, where each of 19 members jot down their estimates for GDP growth, the unemployment rate, and inflation under “appropriate” monetary policy. They also provide a fed funds rate forecast (the “dot plot”). Since there are 19 members, there’s always a variety of opinions (or dots), but generally, the median dot tells you something useful about the Fed’s reaction function—what they might do if the economy followed a certain path, but also they might do if it didn’t.
This time, the dots were a complete mess, and the story was equally incoherent, which is why Fed Chair Jerome Powell told everyone:
“If there was ever going to be a time to skip producing a SEP, this would be it.”
He said that people put something down because they had to. What’s striking was that members just completely ignored what’s happening in the Middle East, with hardly a hint of the impact in the projections. Powell underlined that by saying the whole situation is out of their control, and it’s too soon to know the scope and duration of the conflict’s impact on the US economy.
The median dot was basically unchanged:
- A projected policy rate of 3.4% in 2026 (the current rate is 3.6%, and so that implies one cut this year).
- A policy rate of 3.1% in 2027, implying one more cut next year.
Not a single member projected a rate increase in 2026, and just one projected a rate hike next year.
At the same time, they increased their projections for GDP growth (from 2.3% to 2.4% for 2026 and 2.0% to 2.3% for 2027) as well as their projections for core inflation (from 2.5% to 2.7% for 2026 and 2.1% to 2.2% for 2027). This is presumably driven by optimism around AI-based productivity, as well as increased capex putting some upward pressure on inflation.
Yet there’s a lot of uncertainty here. If you look at the distribution of members’ projections of core inflation, you see a wide range of views. Members’ estimates ranged from 2.1% to 3.0%. But only three members projected core PCE to be 2.9% to 3% at the end of 2026. The other 16 members think it’ll be lower.
Source: Federal Reserve Board’s Summary of Economic Projections (SEP)
This beggars belief for two reasons:
1. Core inflation (defined by the Fed’s preferred metric, PCE inflation) was already at 3.1% pre-crisis, and that’s driven not just by tariff-impacted goods but core services ex-housing as well.
2. The outlook looks quite bad given Middle East events, which will put upward pressure beyond just gasoline prices thanks to higher fertilizer prices, jet fuel prices, and shipping costs.
Setting aside the Middle East events for a moment, the Fed is essentially looking through tariff-impacted inflation and believes inflation will fall once tariffs pass through. In theory, tariffs should result in a one-time price increase, but in the real economy, tariff pass-through can take quite a long time. Still, Powell and Co. believe the tariff impact will pass (aka be transitory) and that’ll send inflation closer to their target.
The Fed doesn’t think core services’ ex-housing inflation is a problem either, despite inflation for this category running at an annualized pace of 4.3% over the past three months and 3.5% year over year, well above the pre-pandemic pace of around 2%.
When asked about elevated core services inflation, Powell responded that a softer labor market ought to drive it lower, but obviously that’s not happening and he’s uncertain about the cause.
In reality, it’s likely the labor market isn’t as soft as weak headline payroll growth suggests. The unemployment rate is low relative to history, and the prime-age employment rate is higher than any time during the last two expansions. Ultimately, wage growth is still running quite strong, and that’s probably why services inflation is hot.
All this would also imply policy is not too tight.
Hope Is the Strategy
If there was one message in the projections, it’s that the Fed is going to treat the energy shock as transitory, or at least hope it is. In the face of the risks, that does make it seem like hope is the strategy, in particular hope that “transitory” means more now than 2022. So let’s put it together. Energy shock? Hope it’s transitory. Tariff shock? Think it’s transitory. Services inflation? Can’t understand it so we’ll pretend it’s not there.
Now, it probably makes sense to look through a supply shock or two. The problem is that we’ve had five shocks in five years:
- The post-COVID inflation surge as supply chains got snarled.
- The Russia-Ukraine war, which sent energy and food prices much higher.
- The tariff shock on goods inflation.
- The immigration shock, likely putting some pressure on wage growth.
- The latest Middle East crisis.
You can dismiss each of these as a one-off and transitory, but when they repeatedly happen (never mind the cause) and have the same upward impact on inflation, that means the Fed is not getting back to their target of 2% any time soon. In fact, over the last five years (2021-25):
- The Consumer Price Index (CPI) has averaged a 4.5% annual inflation rate.
- The Fed’s preferred inflation metric, PCE inflation, has averaged 4.0%.
At some point, 3% becomes the new 2%, but now there’s the possibility that it also starts to creep up to 4%. That’s a problem.
The Fed is clearly aware that they’ve missed their target by a wide margin over the past five years, and despite the dots (which Powell told us to ignore anyway), they’re probably disinclined to cut anytime soon. Or to put it another way, we need inflation to head lower and the unemployment rate to head higher if the Fed is going to cut again. Safe to say, the inflation rate is not heading much lower this year (if at all).
That means rate cuts are unlikely.
But we would go even further. There’s a good chance that the Fed will actually need to shift the conversation to rate hikes. For now, everyone’s focused on higher gasoline prices, which could reverse if the crisis ends soon. But we are on Day 24 of the conflict and the world is now short over 250-300 million barrels of oil from the Middle East, which would have been used in refineries to make all sorts of petroleum-based products that are needed around the globe. This is a recipe for higher inflation across the board, and at some point, the Fed may not be able to ignore the impact—especially if the crisis lasts a few more weeks (let alone months). There’s a reason why bond yields are rising:
- The 2-year yield, which is essentially an estimate of Fed policy rates over the next two years, has surged almost 0.5 percentage points over the last three weeks (to 3.90%).
- The 10-year yield has jumped about 0.45 percentage points to 4.37%.
This is a double whammy because not only does it increase borrowing costs across the economy (like mortgage rates), it also means bonds aren’t providing protection amid a crisis.
The Fed pivoted to a much more hawkish policy path in April 2022, which roiled markets. That was because they waited too long. The longer they wait this time around, the larger the eventual pivot they may have to make, and that’s going to create more volatility in markets. Just don’t be surprised when it happens.
S&P 500 – A capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The NASDAQ 100 Index is a stock index of the 100 largest companies by market capitalization traded on NASDAQ Stock Market. The NASDAQ 100 Index includes publicly traded companies from most sectors in the global economy, the major exception being financial services.
The views stated in this letter are not necessarily the opinion of Cetera Wealth Services LLC and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not take into account the effects of inflation and the fees and expenses associated with investing.
A diversified portfolio does not assure a profit or protect against loss in a declining market.
