Has the stock market bottomed out?

Positive inflation news from the US on Thursday sent share prices higher. Is the stock market ready for a recovery, or is this another false dawn?

Stephen Wright ❯

Stephen has a PhD in Philosophy and teaches at the University of Oxford. He's an enthusiastic Warren Buffett follower and focuses on buying quality businesses at sensible prices. He's also a podcaster with the PlayingFTSE show.

Published 12 November, 2022 8:22 am GMT

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

Encouraging inflation data from the US caused share prices to push higher this week. So could this mean that the stock market is about to recover?

Inflation

On Thursday, the US inflation reading came in at 7.7%. In other words, prices in the US during October were 7.7% higher than they were a year earlier.

The reading this week followed readings of 9.1% in June, 8.5% in July, 8.2% in August, and 7.7% in September. Basically, inflation seems to be declining steadily.

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Lower inflation is likely to be good for investors like me. There are two reasons for this.

The first is that high inflation has been cutting into corporate profits. Both Alphabet and Meta Platforms announced recently that higher costs had been driving down profit margins.

The second is that lower inflation is likely to mean lower interest rates. And when interest rates are lower, stock prices are typically higher.

That’s why the encouraging inflation reading has sent stock markets higher. But there have been a few false dawns this year for investors, so has the stock market finally bottomed out?

Share prices are a function of two things. The first is corporate earnings and the second is how much investors are willing to pay for a share of those earnings.

I expect the positive inflation news to help with the first issue. As businesses don’t have as much pressure on their costs, their profitability should improve.

By itself, this should go some way towards helping share prices recover from their current levels. But I think that the real catalyst for a stock market recovery is interest rates.

Unlike inflation, interest rates affect both corporate earnings and investor sentiment. When interest rates are low, businesses are able to grow more easily and investors are willing to pay more for shares.

Higher interest rates cause both of these to reverse. Funding growth projects becomes more expensive for businesses and investors demand lower prices from possible investment opportunities.

A stock market recovery?

I think that the inflation data is encouraging by itself. It indicates to me that the rate of price increases in the US is beginning to slow and I think that this should be good for corporate profits.

By itself, though, I doubt whether positive inflation news is enough to spark a full stock market recovery. For that, I’m looking for some good news about interest rates.

Inflation and interest rates are connected in an important way. The US Federal Reserve is increasing interest rates to try and bring down inflation.

As such, lower inflation might lead to lower interest rates over time. But I’m waiting for that to happen before planning for a stock market recovery.

As a result, I think that the news concerning inflation might stabilise the stock market for a while. But for a real stock market recovery, I’m looking for some encouraging news concerning interest rates.