The First Warning Shot for a 2025 Inflation Wave

BY MICHAEL SALVATORE, EDITOR, TRADESMITH DAILY

In This Digest:

• A whiplash to start the first week of 2024…
• It’s all about, you guessed it, inflation and the Fed…
• Why we’re not scared, and you shouldn’t be either…
• The rebound odds for one headline stock in particular…
• Two hours until we release TradeSmith’s biggest breakthrough in 20 years (last chance to sign up with one click here)…

It’s a bit like a car accident…

If you’ve ever been suddenly rear-ended while driving, you know what whiplash feels like.

A great thrust forward, testing the limits of your seatbelt… and then a similar lurch backward.

To put it bluntly, whiplash sucks. It’s disruptive, painful, and can cause some longer-lasting injury.

That said, it’s nowhere near as bad as forgetting to buckle your seatbelt and flying out the windshield.

Investors sure felt the whiplash this week. For the first full trading week of 2025, the S&P 500 rose as much as 1.3% from the previous session, only to close lower on the day and just half a point higher from Friday. Tuesday, similarly, saw an initial surge of 0.37% followed by an intraday low of -1%.

The other main benchmarks (QQQ, DIA, and IWM on the chart below, along with SPY) are also feeling the whiplash… with small caps negative for the year at writing.

It’s enough to let the fear center of your brain start to perk up, begging you to sell, sell, sell…

Well, I’ll be the first to tell you that listening to that fear would be like flying through the windshield. The last thing you want to do is aggressively sell stocks in what hindsight later shows was a simple dip. That leaves you battered and bruised by virtue of missing out on a powerful recovery.

The whiplash is strong, there’s no denying it.

But all we’re seeing here, in my humble opinion, is both a consolidation of the massive gains in November… and a reaction to the ever-present top-of-mind factors for investors.

It’s inflation and the Fed…

Inflation data out Tuesday was the main blow to investor optimism. Here’s Bloomberg with the key details:

Growth at U.S. service providers quickened in December, reflecting stronger business activity that helped push a price measure to the highest since early 2023.

The Institute for Supply Management’s index of services advanced 2 points to 54.1 last month, the group said Tuesday. Readings above 50 indicate expansion. The measure of prices paid for materials and services rose more than 6 points to 64.4.

The acceleration in the cost gauge comes as Federal Reserve policymakers adopt a more cautious approach to lowering interest rates. Resilient demand, illustrated by the pickup in business activity and stronger orders, adds to concerns that inflation will remain stubborn.

“Inflation will remain stubborn” has been our calling card since October, when we argued that inflation will at worst reignite this year, and at best remain entrenched.

So far, we’ve seen a whole lot of the latter. And another major inflation catalyst is coming.

Remember the dockworkers strike from a few months back? Well, the International Longshoremen’s Association and the United States Maritime Alliance are back at the negotiating table this week. And the biggest topic is a touchy subject.

The union doesn’t want more automation at U.S. ports. To them, the cost and time savings automation would provide – as demonstrated by many modern foreign ports in countries like China, Australia, Saudi Arabia, and the U.K. – aren’t worth the untenable trade-off of job losses.

I don’t agree with the dockworkers that we should delay automation. But that doesn’t really matter. What does matter is the union isn’t likely to budge on this important issue. And another strike could be at hand in the coming weeks.

The last strike was short-lived, but it threatened to starve the U.S. of imports across hundreds of ports. That sort of supply shock stokes inflation. And if we see one, we should prepare for both more volatility in the market and potentially even less accommodative policy from the Fed.

The market is already pricing in fewer Fed cuts this year. You have to go out to June to find the first Federal Open Market Committee meeting where investors (currently) agree we’ll see some kind of rate cut:

This is all important to be aware of, but remember…

Markets go up far more than they go down. (In data terms, it’s about seven years up for every three years down – more from Lucas Downey on that tomorrow.)

Here at TradeSmith, we don’t let headlines scare us out of stocks. We let the data tell the story.

And right now, the data is telling us to stay long and strong. Here’s the latest look at the SPDR S&P 500 ETF (SPY), with horizontal lines marking its Yellow Zone and Red Zone. Those come into play at about $555 and $521, respectively, with the current price being $591:

So, as I write, stocks are still well into the Green Zone. If they fall another 6%, that’s when we would shift to being cautious and defensive. And we won’t see an all-out sell signal until stocks fall almost 12% from their current levels – well before pundits call an “official” bear market.

Could that happen? Absolutely. But our research shows that you don’t want to shift your strategy until it does.

Let’s take a look at one headline stock…

Nvidia (NVDA) CEO Jensen Huang just put on a celebrated performance at the annual CES trade show, where he unveiled a new line of chip hardware alongside two AI-focused desktop PCs.

All the while, he shared a vision for an AI-powered world that Nvidia is in the best position to serve. (Disclosure, I own NVDA at time of writing.)

The stock initially popped, but has since tanked more than 5% lower.

That’s the first such single-day decline in months. And it got me wondering just how often we’ve seen such declines in NVDA… and what has historically happened next.

NVDA has closed down more than 5% 281 times since the turn of the century. Depending on how long you hold it, the risk/reward ratio varies:

There’s a lot to like and dislike about NVDA’s historical performance after drops like we saw yesterday.

First of all, even with so many cases, the odds of making money on NVDA after such a drop are pretty mixed. Holding out to one month gets your odds of a win just under 56%, hardly a high-odds bet. You’re also earning, on average, just 3% on that timeframe.

Then again, the average win column is something to behold across all timeframes. Whenever NVDA drops and then recovers, the short-term returns from those recoveries are massive.

Similarly massive, though, are the losses. The two-month hold time, despite a substantially higher win rate at 63%, holds an average loss higher than the average gain. That’s noteworthy.

For a stock that’s so important to the market’s success, yesterday’s signal was a warning sign. If we do wind up taking the red path – and odds are good we will, at least over the next five trading days – the market could be due for some more pain in the short term.

Here’s another spot to look for January strength…

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To your health and wealth,

Michael Salvatore
Editor, TradeSmith Daily