CPI Indicating a Market Turning Point Is at Hand?

Includes: DIA, QQQ, SPY
by: Zhong Jin

Wednesday, the CPI for November 2010 was released. The headline CPI increased by 1.1% over November 2009. The core CPI increased by 0.8% over the same month in 2009. Both readings are well below the Federal Reserve’s long term target inflation rate of 2%, reinforcing the Fed’s worrying about deflation rather than inflation.

And worry the Fed should. QE2 has not shown any success in its intended impact of improving employment and lifting inflation in the U.S. But China and a large part of emerging economies have already felt the heat. Nearly all commodities have seen their prices rise sharply in the past two months. The latest CPI growth rate from China is 5.1%, the highest in over two years.

The Fed might have had this scenario in mind when the FOMC decided to implement QE2 last November. In addition to stimulating business investment in the U.S., QE2 causes inflation to rise in emerging economies, which implicitly reduces the cost advantage enjoyed by those regions. The idea then, is that the imbalance between the U.S. and emerging economies could be somehow corrected. However, as the global supply chain is tightly integrated today, the U.S. may have to bear the costs of QE2 before the benefits are felt.

The reason is simple. So far, commodity prices reacted much more strongly to QE2 than CPI in the U.S. The pace of commodity price appreciation is so fast that the adjustment in the global supply chain has not occurred yet. U.S. corporations have already seen their input price hiking. However, since unemployment rates have stayed above 9% for nearly 20 months now, consumer prices in the U.S. have little room to increase further.

As companies cannot pass the higher costs of raw materials to final consumers, in the short term, there are two likely results: The first result is that corporations will have to cut their profit margins since they cannot fully pass their increased costs to consumers. Lower profit margin means less incentive to invest and expand. Another result is to cut other costs (mainly labor costs) to offset rising materials prices. Cutting labor cost will reduce wages, increase unemployment and then put more pressure on consumers. Both results spell trouble for the whole economy and the stock market.

Historical data has proven the above point. The following chart presents the monthly S&P 500 Index and the growth rate of U.S. core CPI minus the growth rate of the Import Price Index from China to the U.S. Since China is often the last step in the supply chain- in assembling and shipping goods to the U.S.- the growth rate of the Import Price Index from China could measure the production costs of U.S. companies (a better measurement than PPI in the U.S.).

Click to enlarge:

The chart shows that the S&P 500 largely lagged the growth rate of core CPI ex the growth rate of import prices from China. More importantly, whenever the core CPI ex-import price moved across zero, a major turning point of the stock market happened in a very short period thereafter or even at the same time.

The import price index from China has only been available since December 2003. In the past seven years, the growth rate of core CPI ex-import price from China has only moved across zero twice. It first fell below zero during the period between the end of 2007 and the beginning of 2008. The S&P 500 index reached its peak during that period. Then, the rate rose above zero at the beginning of 2009. One month later, the S&P 500 index touched the bottom.

After the CPI release Wednesday, the growth rate of core CPI ex-import price is now at 0.4%, continuing its downward trend. Given rising inflation expectations in China and the danger of deflation in the U.S. right now, that rate is falling below zero again. Companies will bear the increasing costs and see their profits fall. Is the next turning point for the stock market right in front of us now?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.