The S&P 500 fell 1.6% last week as investors continue to assess the market impact of the conflict in the Middle East. We’ve seen some big market swings on changing headlines, especially in oil. On Monday, hope was the war in Iran would be over soon, but that quickly lost steam and crude oil soared back up close to $100/barrel later in the week.
There are a couple ways to look at this year so far. We have the war in Iran, software stocks crashing on AI worries, private credit stocks imploding, crude oil up nearly 70% year-to-date, inflation that looks to be more of a worry than most think, a real chance there won’t be any Federal Reserve (Fed) rate cuts this year, and global yields moving higher. When you put all of that together, the fact the S&P 500 is down only 2.9% for the year and down less than 5% from the late January peak is really incredible. But this brings up the question: Are stocks looking past these issues to better times ahead, or will prices turn lower on continued bad news?
The truth is usually somewhere in the middle, but we are on the side that we are still in a bull market that will bring higher stock prices by year end. But that doesn’t mean more churn won’t happen first.
After a 40% rally off the April lows last year, seeing a sideways and choppy overall market since late October isn’t that abnormal. In fact, we think it’s actually quite healthy, with the market catching its breath for a likely next move higher.
OK, so let’s get to some bad news and some good news.
The Bad News
The S&P 500 had a December closing low of 6,721 last year. On Thursday, it closed beneath that, and we’ve found that when the December low is violated in the first quarter of the following year, it can mean trouble.
This happened last year, for instance. Stocks came back by the end of the year, but it was still a warning something was off, and stocks did crash into mid-April. Then there are years like 2008, 2018, and 2022, which all saw the prior year’s December low violated in the first quarter and were all bad years for investors. Here’s a list of all the times this happened. We will note, until 1978 (another Year of the Horse), this was extremely bearish for the full year, but since then it hasn’t been nearly as bad. Still, we’d file this under a potential worry for the bulls.
Interestingly, this is the 38th time the lows in December were violated in the first quarter of the next year. That’s out of 76 years, so there were also 38 times it didn’t happen. Here are those 38 other years, and it’s clear we’d have preferred this scenario.
When stocks stayed above the December low the next year, the S&P 500 was up on the year about 95% of the time and up nearly 19% on average; when the lows were broken, the full year was flat and up a coinflip of the time.
Now Some Good News
We’ve noted many times since early February that the mid-February to mid-March period can be weak historically. We’ve called it the “banana peel period,” and it’s safe to say we slipped on a banana peel this year.
The good news? If you look at the past 20 years, the S&P 500 bottomed on average on March 12 and then moved higher. No, we don’t ever suggest investing purely on seasonals or the chart below, but it does give a nice potential path for higher prices should we get some positive news out of the Middle East.
The other bit of good news is we are seeing some extreme signs of negative sentiment. This is a necessary evil for major lows to form. It doesn’t mean stocks will bottom today or tomorrow, but we are in the ballpark for a potential rally on any good news.
One angle to see this is how much investors are willing to pay up for portfolio protection via options. What we’re seeing right now is in line with previous other times of crisis. When everyone wants insurance and will pay dearly for it, it means a lot of bad news is likely priced in and, as you can see below, previous negative spikes like this have occurred near market lows.
Lastly, credit markets are still functioning. We are seeing some signs of stress, with spreads widening, but by no means are spreads blowing out. We’ve long said the credit markets are the smartest people in the room, and with all the worries over private credit and software and now the war, if a monster was really under the bed, we’d expect to see it show up here, and thankfully it hasn’t yet.
In fact, BBB spreads (the bottom rung of “investment grade” corporate bonds) have tightened since the end of February. That’s some more good news in a sea of bad news.
The Fed May Start Thinking About Raising Interest Rates
Let’s start here: If inflation averages 2% over 10 years, that translates to an 18% cumulative loss of purchasing power, i.e. $10,000 of a typical basket of goods and services today would cost $12,190 in a decade.
- If inflation averages 3% over 10 years, that translates to a 26% cumulative loss of purchasing power, i.e. $10,000 of purchases today would cost $13,439 in a decade.
- If inflation averages 4% over 10 years, that translates to a 32% cumulative loss of purchasing power, i.e. $10,000 of purchases today would cost $14,802 in a decade.
Over the last five years (2021-25), the Consumer Price Index (CPI) has averaged a 4.5% annual inflation rate. The Fed’s preferred inflation metric, the Personal Consumption Expenditures Price Index (PCE), has averaged 4.0%.
The Fed’s official target is 2%. They haven’t gotten close to that in five years, and it doesn’t look like they’re going to any time soon.
We’re still getting inflation data from a couple of months ago (January). But it’s useful to gauge where things were prior to the current crisis, and inflation was already moving the wrong way. A single month’s data can be noisy, and so we’ll broaden the window here.
- Headline PCE inflation rose at an annualized pace of 3.5% from November to January and is up 2.8% over 12 months.
- Core PCE inflation (ex-food and energy) rose at an annualized pace of 3.7% from November to January and is up 3.1% over 12 months (the fastest pace since March 2024).
We’re clearly going the wrong way right now.
Headline—and even core—numbers can hide what’s happening under the hood. Core inflation has certainly been pulled higher by tariff-impacted goods and even higher stock prices (portfolio management services are included in PCE, and that is driven by stock prices). One reason the Fed switched from CPI to PCE back in 2000 is because PCE has a much broader basket of goods and services (and it accounts for substitution effects when people switch from certain goods and services to others). So we looked at 178 items within the core PCE basket and calculated the distribution of year-over-year inflation at four different times. You can see how inflation really broadened out in June 2022 relative to December 2019. The good news up until last year was that the distribution was narrowing, but things were still not quite “normal.” But over the past year, things have reversed:
- In December 2019, just 24% of items had inflation rates above 3%.
- In June 2022, 72% of items had inflation rates above 3%.
- In January 2025, 40% of items had inflation rates above 3%.
- In January 2026, 51% of items had inflation rates above 3%.
Long story short, the inflation picture was not pretty prior to the Middle East crisis. And it’s going to get a lot worse.
Not Just an Energy Shock
It won’t be a surprise to see all the inflation readings (pick your favorite metric) jump next month on the back of oil prices. Oil prices were already rising in January and February and have surged even more over the two weeks since the US and Israel first struck Iran on February 27.
- WTI crude has surged close to $100/barrel, rising 47% since February 27 and +72% year to date.
- Brent crude (more of a global benchmark) is above $100/barrel, rising 42% since February 27 and is +70% year to date.
There’s a lot of commentary around the fact that the US is energy independent, and that is true. The US is the world’s largest producer of oil and now exports more petroleum products than it imports. However, that doesn’t mean too much in the immediate term because US oil companies can sell oil to global customers, and so the largest bid is what determines prices. And right now, there’s a massive bid because of a shortage, as the world has lost anywhere from 10% to 20% of the daily flow of oil it needs.
Moreover, a lot of the oil produced in the US is “light, sweet crude,” but what refineries here in the US mostly need is “heavy, sour crude,” which is imported from Canada and Venezuela. Refineries on the East Coast also need a lighter “medium” grade type of crude oil, which needs to be imported. This is also why an oil and gas export ban, should the administration implement one, will not help. In fact, it’ll hurt US oil producers, as they won’t have anyone to sell to.
All this is why gasoline and diesel prices have surged, despite “energy independence.”
- Nationwide average gasoline prices have hit $3.70/gallon, the highest since October 2023. It was $2.80/gallon just two months ago. We could very well see $4.00/gallon in a couple of weeks if this continues.
- Nationwide average diesel prices have hit $4.97/gallon, the highest since December 2022. It was under $3.50/gallon two months ago, and it looks like the trajectory is higher.
It would be one thing if the impact was just on gas prices, as a quick resolution to the conflict could send prices the other way (lower). But it’s not.
- Higher diesel prices will put upward pressure on food prices, as diesel is used to transport food.
- Fertilizers are made of urea, and that’s being disrupted by blocked exports from the Middle East. Fertilizer costs are surging, and that’ll feed its way into the global food production system later this year.
- Fuel oil prices are surging across the globe, sending container freight costs higher than what we saw in 2008 and 2022, and that’ll pass through to goods prices (and inflation).
- The Middle East is also a big source of helium, and that’s critical for semiconductor manufacturing. South Korean chip manufacturers get most of their helium from Qatar, and any disruption will lead to outright shortages, let alone increase the price of chips, and there was already a shortage prior to the crisis.
The decrease in the oil available is already disrupting production of several products derived from petroleum (in addition to the ones mentioned above). Returning to normal would take several weeks even if the crisis ended today. And the longer the crisis continues, the greater the ongoing disruption and time required to get back to “normal.”
Rate Hikes Are Back on the Menu
As discussed above, the inflation picture wasn’t pretty even prior to the crisis. Just based on that, the odds of any further interest rate cuts by the Fed this year would be much lower. The markets are coming around to this outlook as well. The probability of no more cuts in 2026, based on fed funds futures, was less than 5% just before the crisis started (on February 27). That means the market was pricing in 95%+ probability that the Fed would cut at least one more time this year. That’s shifted a lot, and right now markets are pricing in a 39% probability that the Fed will not cut rates this year. That still implies the market believes odds favor at least one more cut, but the inflation picture says otherwise.
We also have information from options markets, and there’s been a significant shift here as well. Prior to the crisis (February 27), options markets implied just a 7% probability of no rate hikes in 2026. That’s increased to 35% now.
Here’s a line Fed Chair Jerome Powell has repeatedly said since the inflation surge in 2022:
“Restoring price stability is a necessary prerequisite to achieving maximum, sustainable employment.”
We have anything but price stability now, and the outlook doesn’t look great. Don’t be surprised if the Fed starts talking about the possibility of raising interest rates sooner rather than later. Even the minutes of the Fed’s January meeting show some Fed members opening up to the topic:
“Several participants indicated that they would have supported a two-sided description of the Committee’s future interest rate decisions, reflecting the possibility that upward adjustments to the target range for the federal funds rate could be appropriate if inflation remains at above-target levels.”
That was before the current conflict started and energy prices surged.
In our 2026 Outlook: Riding the Wave, we talked about several factors that gave the economy a cushion against potential economic shocks in 2026. Lower interest rates was just one of them. Others included fiscal stimulus, strong business and household balance sheets, the ongoing AI buildout, and strong earnings momentum. Losing one of them (if we’re not talking actual rate hikes) raises risks but does not materially change the picture, although it may shift likely winners and losers. (Bonds look worse right now than they did at the start of the year, as do international stocks, which are more vulnerable to an oil supply shock, although both changes depend on how long the conflict lasts.)
Nevertheless, the US and global economies are more fragile than they were in 2022, or even 2024, and the US is already dealing with modest shocks from tariffs and flat job growth over the last 10 months. The key factor, from a market perspective, is how long the conflict lasts, how much damage is done to oil infrastructure in the process, and how long the Strait of Hormuz remains closed. For now, we’re still watching for a resolution in weeks rather than months, but effects will get stickier the longer the conflict lasts.
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.
