Before analyzing what the data is currently saying what lies ahead, it’s important to first touch on some positive developments from the past week or so.
For example, the U.S.-China meeting over trade was a significantly positive development. Additionally, a new executive order was announced cutting U.S. drug prices by 30% to 80%.
Taken together, these add to the series of incremental macro positives over the past few weeks that have supported the improving positive risk/reward in stocks.
While the terms of the China deal aren’t fully known yet, the expectation is for a substantial reduction from the current exorbitant tariff rates along with significant exemptions. But perhaps more important (and somewhat under the radar), is the drug price reduction news.
Drugs comprise about 1.35% of the current consumer price index basket. An 80% cost reduction would be a 100-basis-point reduction in CPI. In other words, year-over-year CPI would drop from 2.8% to 1.8%:
We can likely all agree the U.S. health system has room to improve. One reflection of that is the U.S. pays three times what other nations pay for drugs (sometimes more):
The executive order requires the U.S. pay “most favored nation” status, the lowest available price.
The momentum being created by these and other positive macro developments are driving the V-shaped recovery in equity markets (as we theorized weeks ago).
Still, despite the continued improving headlines, this recovery remains mostly reviled. Investors remain skeptical. For instance, the latest American Association of Individual Investors (AAII) survey still shows greater than 50% bearish sentiment despite the markets’ massive reversal:
As our readers know, we think this negative reading is a positive contrarian indicator and supports continued market strength. It indicates this market is not in an overheated, euphoric state.
At some point, macro skeptics will have to acknowledge conditions are improving. Also, remember that markets look forward. They seem to be looking past a weak quarter or two due to trade disruptions.
Bullishness Heading into Next Year
This may not be a popular opinion yet, but the current data leads us to believe that the risk/reward for stocks is better today than it was in mid-February when the S&P 500 was at all-time highs. What really matters now is the projected trajectory for 2026. So, let’s discuss five areas pointing to bullishness heading into next year.
First, improved visibility on tariff rates shows the risks are far lower than originally believed.
Next, the popular narrative is there is significant economic weakness ahead. However, the high yield market keeps rallying fiercely, indicating no recession on the horizon:
Third, companies are once again proving to be battle tested after surviving their fifth major test – a series of trials that includes COVID, supply chain shocks, inflation surging, the fastest interest rate hike in history, and now tariffs. And all of that was in just five years.
Fourth, it remains notable how sentiment is shockingly cautious. That’s a contrarian bullish sign (see AAII survey).
Lastly, the April CPI report was encouraging:
Inflation is currently tracking lower than the consensus expectation and hit a headline figure not seen in years.
Core CPI (excluding food and energy costs) came in at 0.24% on a month-over-month basis versus the consensus of 0.27%.
But the underlying details are even more promising.
Shelter and auto insurance remain the largest contributors, punching significantly above their weight. Shelter contributed 0.15%, which was 62% of the overall rise. And auto insurance contributed plus 0.02%, which was 10% of the total inflation gain:
If you exclude these two categories, core CPI is -0.1% year-over-year below trend, at 1.9%.
Understanding Cyclical Market Patterns
These data points make us think too many investors are still focused on “speed bumps.” But unless something turns this into a self-reinforcing downturn with credit contraction, it's reasonable to hypothesize that markets are likely seeing through this already.
In fact, if that wasn't the case, both the financial and industrials sectors would be showing persistent weakness in anticipation of a “looming recession.” This month alone, industrials are up over 8%, clearly not reflecting that risk.
Putting this all together is why we think the risk/reward for stocks today is better than in February. We’d argue that the market’s price-to-earnings ratio should now be rising into year end and expanding as risk premium should be falling.
Put another way, currently our original year-end target of the S&P 500 at 6,600 with a P/E of roughly 22 remains intact.
Understanding this macro data, the only question left to answer is whether the current money flow cycle supports this outlook moving forward. As our readers know, our friends at MoneyFlows (formerly MAPsignals), help us in understanding cyclical market patterns.
Just a month ago, bears ruled as volatility reached multi-year highs. The crowd was in pure panic mode.
Our stance at the time was to remain unemotional and constructively follow the data. Since those lows, there’s been a face-melting rally without significant forced buying. All indices have risen by double digits.
The reason is simple: capitulation stopped and selling washed out.
We’ve seen this before. Our readers know the same pattern emerges time and again.
First, capitulation sends stocks lower. Then outflows dry up. Afterwards, forced buying eventually takes over and sends markets higher.
Where are we now in the cycle? We can look to historical comparatives as a guide.
Let’s start with the “big money” professional investor money flows during the 2020 COVID crash. First there was clear capitulation before selling seemingly dried up out of nowhere. Then, forced buyers stepped up.
The same pattern occurred in 2018:
As for today, are we still waiting for forced buying to take over?
Well, we can see the same historical pattern of capitulation. Then throughout most of the second half of April and early May, selling dried up as the outflows were absorbed.
And last week, as the big China and prescription drugs developments were announced, it appears we’re seeing the start of the forced buying stage:
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