The rally continued last week, with the S&P 500 now up seven weeks in a row for the first time since late 2023. Yes, we remain quite optimistic about the remainder of this year, but we also need to be realistic about near-term expectations, as the stock market has had a historic move off the late-March lows. A potential pause or a little weakness here could give the bull market a chance to catch its breath and could actually be a good thing bigger picture.
No Such Thing as Average
Here’s something that is very important to remember: There is no such thing as an average year when it comes to the stock market. Since 1950, the S&P 500 has had an average return of 9.6%, but gains near that level in an individual year are actually quite rare.
In fact, we found only four times in the past 76 years that saw stocks gain 8% to 10% (or about average). In other words, average isn’t so average when it comes to investing.
Given we are in that 8% to 10% range right now, could we really see stocks finish virtually flat over the next seven-plus months of 2026? We’d say no. In fact, we think having a current return at that “average” level in May suggests the potential for more upside and movement toward our year-end S&P 500 target range of 12% to 15%.
‘May’be This Is a Bullish Clue
We noted at the start of the month why we expected to see potential strength this May, and that has been happening in a big way. With the month now halfway over, we’ve already seen an incredible seven all-time highs, the most in May since 2017. In fact, only 1995, 2013, and 2017 saw this many new highs, and that was for the entire month of May. What happened the final seven months those years? Higher at least double digits all three times and up more than 13.2% on average. The May strength could be another clue the bull is alive and well.
Inflation Looks Hot No Matter How You Slice It—In Seven Charts
The inflation data doesn’t look good no matter how you slice it. The headline Consumer Price Index (CPI) rose 0.64% in July (equivalent to an 8% annualized rate), with the three-month annualized pace running at 7.3%. CPI is now up 3.8% over the past year, the highest reading since May 2023.
As we look over inflation numbers, though, keep in mind that inflation isn’t always bad for stocks, especially if the Federal Reserve is inclined to let the economy “run hot,” which is where we believe we are now. When that’s true, higher prices can mean higher revenue (and margins) for businesses, which can be good for stocks. There may be a comeuppance one day if the Fed has to raise rates sharply to get inflation under control (see 2022), but that’s not where we are now. Until we get there, we believe that thoughtful investors need to understand the upside of inflation for stocks, even if consumers are seeing the downside every time they make a purchase.
The big driver of inflation has been energy prices, with gasoline prices rising over 5% in April, on the back of a 22% increase in March (which was higher than any single month in 2022). Energy commodities (which include gasoline and fuel oil) have now increased more than 28% over the past two months, taking prices to their highest level since July 2022. Back in 2022, prices rose 32% over the first six months of the year. This current spike is larger, and it’s happening quickly.
On top of that, energy services inflation (electricity and utilities) is also elevated, rising at a 9.2% annualized pace over the past three months and 5.4% over the past year.
Meanwhile, food prices (both grocery and restaurant prices) are also rising at a hot clip. Before the pandemic (2017-19), grocery inflation (food at home) ran at an average annualized pace of 0.4%, and inflation for food away from home ran at 2.7%. We’re well above that now.
Food at home inflation is up 3.9% annualized over the last three months and 3.0% year over year. Inflation’s running especially hot for several popular items:
- Meats: +8.8% year over year (y/y)
- Fresh vegetables: +11.5% y/y
- Tomatoes: +39.7% y/y
- Lettuce: +7.9% y/y
- Coffee: +18.5% y/y
Inflation for food away from home is up 3.2% annualized over the last three months, and 3.6% year over year.
It’s too early for elevated food price inflation to be a direct consequence of the Middle East conflict and higher energy prices. While higher prices for diesel (used for transportation) and fertilizer (a by-product of natural gas) should impact food prices, that’s probably further down the road. Of course, that means we could be in store for a more prolonged period of food inflation.
“Core” inflation looks at inflation excluding food and energy, since food and energy are traditionally more volatile. But the reality is that these are everyday items that make up a sizable portion of household budgets. Energy (both commodities and services) and food make up 20% of the CPI basket. Rising inflation for these items puts a real strain on households.
Keep in mind that the Fed targets headline inflation, which includes food and energy (though their preferred metric is the Personal Consumption Expenditures Price Index). They focus on core inflation only to gauge the underlying trend. That trend isn’t good.
Core Inflation Also Has a Lot of Problems
Core CPI rose 0.38% in April, which translates to a 4.6% annualized pace. That’s hot, as is the three-month annualized pace of 3.2%. Core CPI is now up 2.7% over the past 12 months. Inflation is elevated and going in the wrong direction.
Now, a big chunk of core CPI is housing, which makes up about 43% of the basket. This came in on the hotter side in April and reverses some of the softness we saw over the past six months. This is due to a statistical quirk. Missing data in October amid the government shutdown led the Bureau of Labor Statistics to assume there was zero inflation in prices that month. We’re catching up to reality now.
There are some commentators who’ve said that if you exclude housing, core inflation was “moderate,” but that’s not really the case. CPI for commodities excluding food and energy was flat in April, amid fading tariff pressures. Still, the three-month pace is running at 0.9% annualized, and prices are up 1.1% from a year ago. That may not seem like much, but it’s hot relative to pre-pandemic (2018-19), when commodities ex food and energy experienced zero inflation.
At the same time, there are items that are still feeling the impact of tariffs, such as apparel. Apparel prices have risen at an annualized pace of 12% over the past three months and are up 4.2% from last year.
Another category experiencing significant inflation is computer software and accessories, which is seeing the impact of demand from AI. CPI for computer software/accessories is up a whopping 83% annualized over the last three months, which tells you that AI demand is far outrunning supply at this time. This barely impacts core CPI because it’s only 0.04% of the basket, but it makes a bigger difference for the Fed’s PCE inflation, the Fed’s preferred metric, where it accounts for about 1% of the basket.
All of that is on the goods side, but inflation is problematic even if you look at core services excluding housing. Prices for this category rose 0.38% in April, equivalent to 4.6% annualized. The three-month annualized pace is 3.2%, and prices are up 2.7% year over year, well above the 2017-19 trend of 2.1%.
Here’s a summary of some different ways of looking at inflation, including a couple of other measures that try to capture what’s going on at the core of inflation. It’s clear the problem is broad and not isolated to just energy, or tariffs. Across these measures, the three-month pace is mostly hotter than the 12-month pace, which tells us that momentum is in the wrong direction. In addition, all the readings are above the 2017-19 trend. In short, inflation is elevated and going the wrong way no matter how you slice it.
Bonds Don’t Like the Inflation Backdrop, but Stocks Do (For Now)
The most direct impact of the inflation backdrop is on the bond market. Short- and long-term yields are at the highest levels we’ve seen this year and reflect the real cost of the Middle East crisis and underlying inflationary heat. US Treasury 2-year and 10-year yields have risen to their highest levels this year even with the equity market reaching all-time highs. (Keep in mind that bond prices fall when yields rise.)
- The 2-year Treasury yield has risen from 3.37% on the eve of the war to 4.08%.
- The 10-year Treasury yield has risen from 3.94% to 4.59%.
As we discussed in our 2026 Outlook, we expected an inflationary growth environment this year, and that’s where we are. That environment is not great for bond yields and general borrowing costs, but the labor market is holding up well. With inflation high and rising and a solid job market, normally we’d be talking about rate hikes. However, the Federal Reserve under incoming Chair Kevin Warsh is expected to hold rates steady for the rest of the year. That’s a potential tailwind for stocks, as is the boost inflation can give to sales growth (even if unit growth grows more slowly) and margins. We can see some of the effect in the aggregate earnings numbers. According to FactSet data, with 91% of S&P 500 companies having reported Q1 results, the blended year-over-year earnings growth rate is 27.7%. If we end the quarter there, it will be the highest growth rate since Q4 2021. Despite inflation, and even partially because of it, stocks have been doing just fine.
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.
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