The CPI And the Market Built on Sand

Facts are simple and facts are straight

Facts are lazy and facts are late
Facts all come with points of view
Facts don’t do what I want them to
Facts just twist the truth around
Talking Heads

The CPI report was released last week and showed mild inflation of 0.2%. This was less than the expected 0.3% and the market ended the week up almost 2%.

The CPI is a bundle of differently weighted products that consumers buy. Consider the actual data:

Now, if the unadjusted data were to be used, April inflation would have clocked in at a runaway 0.8%. That’s an annualized 10% inflation rate. That’s about what we would expect considering that food and fuel prices have surged.
* Food index: unadjusted April inflation is 0.8%
* Household utilities (which is basically gas and electricity) index: unadjusted April inflation is 2%
* Gasoline index: unadjusted April inflation is a whopping 5.6%. That’s an annualized 67%, which is about how much the price of oil has risen.

So why does the gasoline index suddenly change from a 5.6% rise to a -1.9% drop? Especially when household electricity isn’t similarly massaged.
The answer: government statisticians at work. March and April are traditionally heavy driving months so the CPI formulas neutralize any jumps in fuel prices. Although oil prices jumped 20% March-April, the CPI will erase them.

But, come May, the story will be bleak. Even a partial reversal, say from -1.9% to +2%, will drive CPI back up to 0.4%. That's double the Fed's target.

Take another look at that chart. Divide it into things people want and things people need.
Need (61% of total): Food, Housing, Home utilities, Fuel, Education
Want (21% of total): Furnishings, Apparel, recreation, communication, Other
Grey Area (18% of total): Transportation excluding fuel, Medical

The Need CPI is rising fast and it represents most of people’s disposable income
The Want CPI is mainly negative, with offsetting rises in Apparel and communications
The Grey Index is mild. One could argue that transportation belongs in the Want category, but not everyone can postpone buying a car or avoid public transportation. Similarly, Medical could be both a need (necessary care) or a want (deferred elective surgery or insurance) .

My conclusions are:
1. Good news today is very bad news tomorrow. Officially reported CPI will spike up starting next with the May numbers. This is entirely due to oil prices and the manner in which they are reported.
2. No more Fed interest rate adjustments for a while. The Fed reads these numbers the way I do. They know that inflation is running hot, just as they know that they are exporting inflation around the world. The Fed believes that a softening economy will lead to soft demand and therefore lower CPI. In fact, they seem quite willing to trade-off high inflation if it leads to an economic turnaround. But I would guess that there is a limit – separate comments last week by Bernanke and Yellen alluded to concerns about inflation. Perhaps the Fed expected some inflation and has been surprised at the huge jump
3. Consumer belt tightening will accelerate. Avoid any consumer durable company. Expect massive use of the credit card to manage finances. This spells recession.
4. Lower corporate margins as vendors get squeezed. Inventories will remain lean and vendors will layoff employees. Factory spending will similarly drop and so will equipment orders (machinery, forklifts, etc). More earnings and sales negativity

Go back to my 2nd point above: inflation is going global. The Fed's gamble is that the economy will turnaround just in time before inflation does any real damage or the counter actions become too severe.

Certainly a lot is being thrown at the situation
* Loose lending: rates at 2% and ~$700B in loans to banks
* Consumers getting $117B in stimulus checks
* Massive central banker coordination

Several things are working against the Fed's Plan:
1. Consumers aren’t spending or planning to spend

• Consumer Confidence is at a 28 year low http://www.bloomberg.com/apps/news?pid=20601087&sid=aqqGY5BrKuoA&refer=home
  Fell to 59.5 from 62.5, the lowest since June 1980
• Consumer Spending is flat: retail in inflation adjusted dollars is flat. And when gasoline is subtracted, spending on non-gas items has plummeted. Kohls and JC Penny have reported the pullback is already cutting deeply into their profits
• Future spending will drop. The index of consumer expectations for six months from now (monitors the direction of consumer spending) dropped to 51.7 from 53.3.
  
  Look at the chart below. this is the University of Michigan's consumer confidence chart
  Consumer confidence has collapsed from 95 to the 50s in 1 year. A collapse of that magnitude usually presages a recession and stock market collapse. Because in a consumer driven economy, a sudden wave of belt-tightening forces everyone into a slowdown.
  
  
  
  

2. Manufacturing is weak (http://www.bloomberg.com/apps/news?pid=20601103&sid=aLvQshBDjL8w&refer=us)

• Housing is collapsing. Home construction is at a 17 month low http://www.bloomberg.com/apps/news?pid=20601087&sid=abWYAJPuHSAY&refer=home
• Manufacturing has contracted in 4 out of the last 5 months
• Factories are running below 80% utilization
• Jobless claims jumped to a 4 year high (http://www.reuters.com/article/businessNews/idUSN0134793720080501?feedType=RSS&feedName=businessNews)
• Planned job cuts rose 68%
• Construction spending fell a steep 1.1%

The bulls are grasping for lifelines. Manufacturing may be weak, but it isn't getting significantly worse. There is always exports

3. Rest of world is starting to stagger

• IMF cuts global growth expectations to levels not seen since the last recession http://www.reuters.com/article/businessNews/idUSN0320495520080403?feedType=RSS&feedName=businessNews Now Europe, Japan and the US are expected to slow. Almost everything hinges on China and the Oil countries. But the oil countries depend on oil prices and demand staying strong. Again, it all depends on China.
• EU retail sales have started to drop (http://www.bloomberg.com/apps/news?pid=20601087&sid=afhTTwURIcmQ&refer=home)
• Housing price troubles are popping up everywhere. England (housing falls for 1st time in 12 years http://news.bbc.co.uk/2/hi/business/7374730.stm), Canada (http://www.canada.com/calgaryherald/news/story.html?id=aaeaedfd-3f35-4c4c-886b-9c3310b98e4a), Australia (http://www.news.com.au/heraldsun/story/0,21985,23594829-661,00.html) , Spain (http://www.csmonitor.com/2008/0411/p04s04-woeu.html ) (http://www.guardian.co.uk/money/2008/apr/20/expatfinance.houseprices)

4. Inflation will not follow historical trends of following growth down

This is conjecture, but much of the inflation is caused by shifts in long-term demand for food, energy, and infrastructure. US inflation won't drop if Chinese demands doesn't slacken. And oil supply/demand equilibrium is too close.

But this need not be horrible. Even inflation of 5% is low from a historical standpoint. It certainly isn't the Reagan or Carter era level.

So the signs are there - the economy is weak and getting much, much weaker. It will show up in the stock market eventually. The issue is whether the Fed's monetray policies (the easy money) are going to keep the market up as proof of recession emerges and becomes incontrovertible.