Phantom Menace

D-Day: From Debasement to Disintermediation

Soundbite: The AI-driven selloff in certain stock groups has been nothing short of stunning. Fear of AI disintermediating legacy players in various industries has created dramatic drops:  software has been in the crosshairs, but real estate, private wealth, and trucking have also been victims of instantaneous selling. Meanwhile, materials, energy, industrials, and utilities, along with consumer staples have been roaring ahead. This matches the pattern into 2007 where there appeared to be a redistribution of leadership, but what happened was a sequence of rolling tops by sector that is part of the topping process in the broad indices. This certainly does not rule out new all-time highs into Q2 2026, assuming no break of 6,720 in the S&P in the near term, but the need to understand where capital is moving and why is paramount.

We describe the recent market action as nothing short of “contained craziness”: twenty percent of the S&P 500 component stocks have fallen over seven percent in a single day. That type of action is normally reserved for sharp bear markets, yet the S&P 500 is sitting near all-time highs. The 2000 tech bubble is the closest analog, and if we follow that path, brace for a sustained market environment where more of these extreme selling bursts occur on the way down. We draw a line in the sand at 6,720 on the S&P cash index. Below that region, expect continuation lower, perhaps as deep as an additional ten to fifteen percent. Players could sell strength then turn bullish again from that lower level. The bullish target of new highs should lie in the region between 7,150-7,250. 

Markets do not make up their mind at once.

Looking back at 2007, financials, consumer discretionary, and health care stocks peaked five months before the S&P topped out in October. Other sectors such as energy and utilities were still rising after the S&P’s record high had already reversed lower. That is how the phrase “a market of stocks, not a stock market” came to be.

Similarly, we have seen the baton pass from theme to theme rapidly over the past year:

• First came the debasement trade where capital flowed out of U.S. stocks and bonds into Europe and Asia, and precious metals.
• Then, fear over hyperscaler capex spending took over. Investors began to question returns as capex-to-cash-flow ratios doubled to 80% after 2023, when OpenAI became a household name.
• In the latest installment of “Hulk, Smash,” we are witnessing decimation at any mention of AI taking market share from legacy companies.

In the clearest example of the “Get Out of Software” theme, Microsoft is by far the best performer when considering trailing 12-month cash flow metrics relative to META and Google, while Oracle and Amazon have seen their trailing four-quarter free cash flow go negative. However, because Microsoft is a software company, it has fallen over 20% in a little over two weeks. The poor company is now worth less than $3 trillion dollars—a true hardship.

These types of vigorous rotations, as investors thrash from one extreme to another, is characteristic of major trend changes. But within the chaos, opportunities arise.

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The Small Short

Soundbite: The Federal Housing Association (FHA) tightened terms on its loan modification program in October, making it very difficult for struggling homeowners to stay in their homes. Now, to qualify for a modified loan, you need to make three consecutive monthly payments, which sharply increases the chances these mortgage holders end up in default. Mortgage loan analyst John Comiskey estimates 250,000 to 400,000 loans are currently experiencing significant distress. 

For the last four years, if you did not vacate your house or maintained minimal communication with your mortgage servicer, there was always a loan modification available. During that period, many homeowners who could not truly afford their homes were able to stay. Now the tide is going out, and the true delinquency levels will become evident. This fallout will lead to forced sales or foreclosure, in a milder version of 2008. 

Michelle Bowman, Fed Vice Chair for Supervision gave a speech yesterday to bankers where she cited financial stability concerns related to nonbank mortgage companies (NMC), who have increased their market share of the mortgage servicing market from 5% to 55%. Banks have diminished their involvement in servicing mortgages after being burned during the 2008 housing crisis and from higher regulatory burdens. Bowman made it clear that she views the greatest risk from MNC’s as the fact that the “regulatory and resolution frameworks for these mortgage companies have not kept pace with their growth.” This is problematic because even marginal increases in mortgage delinquencies can impair the viability of these mortgage servicers. This could have repercussions—any turbulence among MNCs that drains liquidity could also increase bank risk aversion toward mortgage lending, reducing system-wide liquidity and potentially spilling over into the equity and bond markets.

The inherent risks presented by nonbank mortgage companies were outlined by a recent report from the Financial Stability Oversight Board:

“NMCs’ vulnerabilities can amplify shocks to the mortgage market and thereby pose risks to financial stability. However, because NMCs focus almost exclusively on mortgage-related products and services, shocks to the mortgage market can lead to significant deterioration in NMC income, balance sheets, and access to credit simultaneously.”

Before you run out to sell everything, it’s important to put things in perspective: 2008 saw 2.3 million homes with at least one foreclosure filing compared to the 400,000 top-end estimate related to current FHA actions. There are also nearly 160 million Americans in the workforce today. Still, because stress in nonbank mortgage companies can cause problems throughout our financial plumbing, we are on alert. This is a development to monitor.

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CPI Report: No Conspiracy, Just Process

Soundbite: There are questions surrounding the credibility of government statistics. Was Friday’s CPI inflation report legitimate? Sort of. Truth one: actual January core CPI was probably 0.3% higher than reported. Truth two: the government did not manipulate the data to push the Fed to ease. Can both statements be true? Yes, and the reason lies in the shutdown that caused October CPI data to go uncollected, which forced rent to go to zero in the yearly inflation calculation. That was not a devious move by the current administration, but a consequence of how the Bureau of Labor Statistics (BLS) rules were written years ago. We are left with a misleading impression that the yearly inflation rate is lower than its actual level. However, because the BLS “collects rent data from each sampled unit every 6 months” the downward bias will reverse in May when the April CPI data are released. At that point, we will most likely see an overshoot higher in the inflation data.

The message is not to expect low inflation data forever, but to prepare for distorted annual data for the next several reports. In the meantime, focus on the month/month annualized statistics. Core January CPI rose 0.3% month/month, which translates to a 3.6% annualized inflation rate, versus the 2.5% year/year figure.

Importantly, one of the FOMC’s favored inflation figures is “supercore” inflation, defined as core services excluding rents. The annual data fell toward 3%, leading many to conclude that the Fed will believe sticky services inflation is becoming benign. However, on a monthly basis, supercore posted its third largest increase in three years. Seasonally adjusted, the monthly annualized rate was over 7%. If we are seeing this, rest assured that the army of economists at the Fed are on top of it as well, and the FOMC voting members have the correct perspective. They will be acutely aware that inflation is not converging to their target.

We have been involved in financial markets for over four decades, and we are all too familiar with the frequent distortions in the CPI data. For example, used car prices were higher in January, but after a seasonal adjustment, they were reported as falling almost 2% in January. That helped lower core goods inflation (20% of the overall index) from 1.4% to 1.1%. Used car prices are one of the most volatile components of inflation, so we would not be surprised to see used cars reversing higher, potentially joining rent inflation data as a factor pushing inflation up in the future.

If conspiracy theorists are correct, and the BLS wants to construct an illusory decline in inflation, they may have their work cut out for them. The Peterson Institute is forecasting higher inflation, pointing to immigration policy keeping labor markets and wages tight, along with expected stimulus checks ahead of the midterm elections that would add to already stimulative fiscal policy. Combined with other inflationary forces such as onshoring, they expect inflation reports above 4% this year. If that occurs, it would certainly prevent the Fed from cutting rates (unless we fall into recession). 

Final thought: In September, the Cleveland Fed estimated the neutral Fed Funds rate at 3.7% with an 80% probability. That placed the central bank’s monetary policy in slightly restrictive territory. However, now that the Fed cut rates another 75 basis points to the current 3.50%–3.75% target range, policy is no longer deemed restrictive.

Do not expect quick rate cuts based on illusory annual CPI figures.

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What to Look for This Week

(All times E.S.T.)

1. Friday, February 20 at 8:30 a.m. Personal Consumption Expenditure Price Index for December (PCE). Since Q2 2025, Core PCE inflation has ranged between 2.7% and 2.9% with the most recent data in November coming in at 2.8%. Consensus is for 3% and the Cleveland Fed’s Inflation Nowcasting expects December and January core to come in flat to last month and fall toward 2.6% for February. Again, focus on the month-over-month annualized inflation number given the aforementioned annual calculation distortions.
2. Wednesday, February 18 at 9:15 a.m. Industrial Production for January. The data has diverged between strength in Energy and Defense industries versus weakness in Durables, especially Motor Vehicle manufacturing. Since December, XLI, the industrial ETF, has outperformed the S&P 500 decisively. The headline number has struggled to stay above 2% trend growth.
3. Thursday, February 19 at 8:30 a.m. Initial Unemployment Claims for the first week of February. The last two weeks saw a big reversal high in Claims that pushed the 4-week moving average to its highest level since November. This contradicts January payroll strength, and Claims has leading tendencies unlike nonfarm payrolls, which is a coincident indicator.

FOMC Voters Speaking: Tuesday, February 17 at 12:45 p.m. Michael Barr speaks and the Fed Minutes from the January 27-28 FOMC meeting are released at 2:00 p.m. Wednesday, February 18 at 2:00 p.m. Vice Chair for Supervision Michelle Bowman speaks. She speaks again Thursday, February 19 at 8:30 a.m., followed by new FOMC voter President Neel Kashkari of the Minneapolis Fed at 9:00 a.m. Dallas Fed President Lorie Logan speaks Friday, February 20 at 1:15 p.m.

Earnings: The season is winding down. The calendar is light on tech this week, with semiconductor company Analog Devices Inc. (ADI) reporting Wednesday, February 18 before market. Thursday, February 19 before market Walmart (WMT) and Deere & Company (DE) report. This may give us some new information on consumers shopping down, and on business expansion, respectively. After market on Thursday, Rio Tinto Group (RIO) will talk about materials demand, and Newmont Corporation (NEM) may discuss hedging activity and mining/production costs.

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By Peter Corey

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