Stocks Rise as Market Catches Its Breadth

Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company. 

Equities surged last week, and bond yields declined thanks in large part to encouraging inflation data. The Dow Jones and S&P 500 had their strongest week since early November, while the NASDAQ had its best showing since early December. Perhaps more important than the gains was the breadth of strength (the number of stocks that rose versus declined in value). Last week was the first time this year that the average daily breadth was positive for the week and only the second time since the end of November that saw more stocks gaining in value than declining. The improved breadth propelled the equal-weighted S&P 500, Mid-Cap and Small-Cap stocks to outperform the market cap-weighted S&P 500 and trounce the Magnificent Seven for the week. 

As we’ve noted during the past several weeks, market breadth has been anemic, as investors have grown increasingly concerned that elevated inflation and a seemingly strong job market may cause the Federal Reserve to take a conservative stance toward rate cuts. The fear is that if the Fed doesn’t cut rates quickly or by a significant amount, elevated rates will continue to weigh on consumers and sectors of the economy that have struggled due to higher borrowing costs. Eventually that weakness will spread. These concerns have played out with the oft-discussed Magnificent Seven gaining, thanks to perceptions that they are largely insulated from the economic cycle, while the majority of the market struggles. 

Last week’s broadening of the market was sparked by milder than expected inflation data and relatively strong economic data that featured a sharp rise in small business optimism—an area of the economy that has been under pressure recently (as we will detail later in this commentary). The disinflationary process had shown signs of stalling during the past few months, and last week’s modest improvement raised the prospect that it has restarted. As a result, we saw an increase in investors’ expectations about the Fed’s ability to cut rates and ride to the rescue for sagging parts of the economy.  

Perhaps more noteworthy is that recent yields on two-year Treasurys pointed to some concern that the Fed may need to raise rates given the recent stalling of the disinflationary process. Yields on two-year Treasurys (an indicator of where Fed rates may be headed) rose above the current Fed Funds rate by the most since March 2023 on three separate occasions (January 10, 13 and 14) before dropping below the Fed Funds rate on the day the CPI data came out. While we are encouraged by the most recent readings of inflation in both the Consumer Price Index and the Fed’s preferred measure, the Personal Consumption Expenditures Index, we would like to see more progress on prices as well as signs that economic strength is spreading. Absent that, we view investors’ reactions to the data last week as simply another sign of the importance that broadening economic strength will have on market performance in the coming months. 

While last week’s gains were impressive, it’s important to remember that they followed sharp losses the previous week. A stronger than expected jobs report, concerning inflation data in the Institute for Supply Management’s (ISM) report on services, and the University of Michigan’s Consumer Sentiment Survey showing signs that consumer expectations about inflation are on the rise all resulted in selling pressure. That’s because the data highlighted the potentially difficult task ahead for the Federal Reserve as it attempts to navigate the delicate balance between supporting the labor market while also not rekindling inflation. Simply put, the longer rates remain elevated, the more debt reprices and the greater the chance that the weaker parts of the economy continue to weigh on the strong areas.  

This parsing of each data point in anticipation of how it may factor into the Fed’s thinking suggests that investors are uncertain whether the economy can broaden on its own. Indeed, as we discussed in our latest Quarterly Market Commentary, market performance throughout 2024 was largely driven by evolving expectations about rate cuts. While we expect the path of interest rates to continue driving relative shifts in asset class performance in the nearer term, we believe there are opportunities in the markets for investors who can look past the near-term noise and focus on the intermediate and longer terms. We believe areas that offer meaningful potential are those that are trading at relative discounts to Large-Cap peers and that will benefit as the markets broaden. 

Wall Street wrap 

Improvement on the inflation front: The latest Consumer Price Index (CPI) from the Bureau of Labor Statistics showed that prices rose 0.4 percent in December, up 0.1 percent from the prior reading and in line with Wall Street estimates. On a year-over-year basis, the headline figure was up 2.9 percent. However, core inflation, which excludes volatile food and energy costs and is the measure that the Federal Reserve focuses on, rose 0.2 percent in December, down from the 0.3 percent recorded in each of the past five months. Over the past 12 months, core CPI is now up 3.2 percent year over year. On a year-over-year basis, core inflation has been stuck in a narrow range between 3.2 and 3.4 percent for the past eight months, with the monthly advance bottoming at 0.06 percent in June. 

Goods prices rose for the fourth straight month after having fallen during 14 of the past 15 months. While the uptick was modest, the change in trend is something that we are keeping an eye on given that the change in goods prices has driven the disinflationary process over the past couple of years. Services prices increased 0.3 percent in December, and on a year-over-year basis prices for services are up 4.4 percent. Because services readings include the lagging housing category, we typically look at so-called “super core” services excluding shelter to get a clearer picture of current measures of price pressures on the services side of the economy. Super core services prices, excluding shelter, were up 0.21 percent for the month and are up 3.5 percent on a three-month annualized basis. This is an improvement over November’s three-month annualized pace of 4.3 percent. 

Inflation measures by some of the regional Federal Reserve banks, designed to gauge overall trends of inflation, show mostly improving trends, albeit with work still to be done to get inflation back to 2 percent. The Cleveland Federal Reserve’s calculation, called the Cleveland Median CPI, came in at 0.3 percent in December—slightly higher than November. On a three-month annualized basis, the measure is up 3.34 percent, and the year-over-year reading comes in at 3.80 percent. Similarly, the Atlanta Fed’s Core Sticky measure was up 2.8 percent on a one-month annualized basis, with the year-over-year reading checking in at 3.8 percent. Like the other measures, this data shows that progress has been made in bringing down inflation but that more work needs to be done. 

Small business owner optimism climbs: The latest data from the National Federation of Independent Businesses (NFIB) shows that optimism among small businesses rose 3.4 points in December, with a reading of 105.1, the highest reading since October 2018. The gain comes on the heels of November’s sharp rise in optimism and marks the second straight month the index came in above the 50-year average of 98. The improved outlook was widespread, with seven of the 10 components measured showing increases, two showing a decrease and one unchanged. Additionally, the Uncertainty Index fell to 86, declining 12 points for the second consecutive month. For further context, the uncertainty index hit an all-time high in October of last year.  

A closer look at the report shows that expectations drove the gains in optimism, while readings on current positions improved modestly but remained strained. For example, the net percentage of respondents who expect the economy to improve rose 16 points in December and is now at the highest level since 1983. “Optimism on Main Street continues to grow with the improved economic outlook following the election. Small business owners feel more certain and hopeful about the economic agenda of the new administration,” NFIB Chief Economist Bill Dunkelberg said in comments released with the report. 

Optimism about the future was evident in the sharp rise in sales expectations. Sales for small businesses have been in decline since June 2022, including the latest reading showing a still historically depressed 13 percent more businesses reported declining sales than reported flat or rising purchases, unchanged from December. Despite the stretch of weakness, the latest survey shows that business owners are increasingly confident about a reversal of fortune, with a net 22 percent of those surveyed expecting sales to grow in the next three months. This marks an eight-point improvement from November and the highest reading since January 2020 (before the pandemic hit). For further context, the measure hit a recent low in August 2024, when a net 18 percent of businesses expected falling or flat sales in the next three months. 

Should the rising sales materialize, it could provide a welcome boost to businesses that have endured sagging earnings trends since the arrival of COVID. The latest reading shows a net 26 percent of business owners have seen their earnings shrink over the past three months, unchanged from November’s reading. Although the latest reading is still very weak, the trend has shown some improvement since August 2024, when a net 37 percent of businesses reported shrinking earnings.  

Despite a second straight month of strong gains in optimism, the portion of businesses expecting to hire in the next three months showed only modest gains in December. The latest results show 19 percent of companies expect to add to payrolls, an increase of one point from November. Those who are hiring continue to struggle finding qualified help, with 49 percent of those hiring reporting a lack of qualified candidates. While a scarcity of qualified workers can lead to a spike in wages, it is unclear whether that is the case as of yet. The latest survey results show that 24 percent of respondents expect to raise compensation in the next three months, a decline of four points from November but at the second highest level since January of last year and well above a recent low of 18 percent in July 2024. 

The latest results show pricing power held steady, with 24 percent of small companies raising prices over the past three months, unchanged from November and tied for the highest level since June. For context, this is well off the post-COVID peak of 65 percent in May of 2022 but still elevated by historic standards.  

Beige Book points to moderate growth: The latest release of the Federal Reserve’s Beige Book, which provides real-time anecdotal assessments of business conditions across the country, showed the pace of the economy improved moderately from the prior reading, with each of the 12 districts reporting growth ranging from slight to moderate. The latest report is an improvement from the prior release, in which two districts reported flat or declining business activity. While improvements in activity were modest, businesses in most regions expressed optimism about the economy going forward, although contacts in several districts expressed concerns about changes in immigration policy and tariffs that could create headwinds to growth. 

The latest report marks the second in a row that points to an uptick in activity. Still, manufacturing remained a sore spot, with activity in the sector decreasing slightly as a whole. It's worth noting that the improvements captured in the latest two Beige Book reports could weigh into the Federal Reserve’s thinking on rate cuts. As you may recall, the September report described growth as flat or declining, which we believe contributed to the Federal Reserve’s decision to cut rates by 50 basis points as opposed to a more incremental approach of 25 basis points.  

Most districts reported modest price growth. However, there were some reports of flat or modestly declining prices in retail and manufacturing. Input prices also increased overall, but several districts also noted flat or declining input costs. Once again, contacts in the districts expect the current pace of price growth to persist, but businesses in several districts noted tariffs could lead to price increases.  

The latest report showed flat or slight increases in employment, with half of the districts reporting slight growth in hiring and the remainder reporting no growth. The muted growth in hiring reflected difficulty finding skilled workers and a low level of layoffs. Despite employment being little changed, most districts reported that the pace of wage growth was moderate. 

Retail sales up modestly: The latest retail sales numbers from the U.S. Census Bureau show that consumer spending cooled but remained strong last month, with overall retail and food service sales growing 0.4 percent in December, down from November’s upwardly revised pace of 0.8 percent and shy of Wall Street estimates.  

Despite the easing pace in total sales, the advance was broader than last month, with ten of the 13 categories rising. Overall retail sales are up 3.9 percent year over year. 

Total building permits decreased in December by 0.7 percent to 1.483 million. Single-family permits were up 1.6 percent from the prior month to 992,000. Multifamily permits came in at 437,000, a decline of 5.8 percent. 

The week ahead 

Wednesday: The Conference Board’s latest Leading Economic Index Survey for December will be out mid-morning. Recent reports have shown modest improvement but still point to weak economic growth ahead for the U.S. economy. We will be scrutinizing the data for any indications of a change in the pace of the slowdown. 

Friday: We’ll get an update on the health of manufacturing and services in the U.S. when S&P Global releases its Flash Purchasing Manufacturers Index reports for January. Activity rose last month in services, while manufacturing slowed further and remains in contraction. We will be watching to see if the bullish outlook sparked by the conclusion of the presidential election is still intact. 

We’ll get additional insights into the housing market when the National Association of Realtors releases existing home sales for December. This report, along with the new homes data released last week, should give a clearer picture of whether the housing market remains stalled due to high interest rates. 

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