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Five Things You Need to Know: No One Is Driving the Train

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The return of stagflation? No, it's just the end of inflation.

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Kevin Depew's Five Things You Need to Know to stay ahead of the pack on Wall Street:

1. The Return of Stagflation?

Bloomberg Headline: Housing, Price Reports Raise Stagflation Fears

Grim as expected, housing starts fell 11% in July as builders broke ground on the fewest homes in 17 years. That's good. It demonstrates that even blind faith optimists have a pain threshold that cuts against denial. I was beginning to think some of these builders lacked the spasmodic gulping reflex that prevents normal human beings from drowning themselves to death while simply trying to get rid of the hiccups.

Meanwhile, the Labor Department reported producer prices soared nearly 10% higher than last year. The snap judgment that follows is that this cocktail of data has plunged us deep into Stagflation.

"There's no doubt we're in a period of stagflation now," Bank of America (BAC) senior economist Peter Kretzmer told Bloomberg. For all I know he's probably right, but stagflation is a transfer station, not a hub, and we have a long, long way to... Holy Mother of Mary and Revelations!!! There's this bizarre news on the wire RIGHT NOW about a Dallas fisherman claiming something about snagging a feverish BEAST with digestive problems and some kind of ooze seeping from bursting pustules...

Never mind all that. I misread something in the story. It was not a Dallas fisherman at all. It was the President of the Dallas Federal Reserve, Richard Fisher, who in a speech earlier today said, "The recent burst of cost-push inflation is giving the beast digestion problems that might manifest themselves in the form of a lingering inflationary fever."

Clearly, things are even worse than I thought. When GOVERNMENT officials talk publicly and openly about strange BEASTS and FEVERS and things BURSTING open it means the whole train is off the rails. There's no stuffing talk of beasts back into the bottle and pretending you were joking. I once read a study claiming that the average person hears only about every seventh or eighth word of a 2,000 word speech. But they will latch onto something like BEAST and FEVER and ACT accordingly.

This can only mean terrible things are in store for Dallas. But I am only one man, and so from here in New York City I have no choice but to focus on the things within my immediate reach that I can control; various liquids and food items, scissors, assorted gels and the raw data release from the Labor Department focusing on the Producer Price Indexes.


2. Inside the Producer Price Index

I've always had a thing for numbers, a fascination with how dangerous they are, how easily they can be used to both shade the harshness of truth and char the eyeballs of bald-faced liars. Make no mistake, when a cop shines a Pelican 7060 LED Flashlight (130 lumens) in your eyes and asks how many drinks you've had, there's nothing haphazard or hollow about the question. Years of intensive psychological and physical training have gone into that tactical procedure, and the only answer under such dire circumstances is the right one, the truth.

So what's the truth behind these Producer Price Index numbers? Highest annual rate in 27 years? We better stop the car before we get the full-on Pelican 7060 treatment. Twenty-seven years? 1981? That's probably a felony. Clearly, there are some things we need to understand about this datapoint, so let's take a look.

The Producer Price Index tracks the prices producers receive for the stuff they make. It used to be called the "Wholesale Price Index" up until the late 1970s, but the name was changed to "Producer Price Index," probably because advertisers created widespread confusion and hysteria among government data collectors by offering stereos and eight track tapes at wholesale prices instead of retail prices.

Think about it. If you are the poor bastard at the Labor Department charged with collecting producer and consumer price data, you can't have retailers selling Uriah Heap eight tracks for wholesale - $6.99, maybe even less. That's the kind of steep price discounting that confuses the numbers and ruins everything. But that's neither here nor there. We're supposed to be focusing on the Producer Price Index... and what it all means.


3. How to Read Between the Lines

The Bureau of Labor Statistics tracks Producer Price Index data through a sampling of producers in the manufacturing, mining and service industries. Together, we're going to comb through this thing like the professionals we are. Then, you can feel free to abuse yourself at your own discretion, on your own time, by looking at the report each month here.

First, there is the so-called "headline" number, which is typically the first sentence in the Labor Department's release:

"The Producer Price Index for Finished Goods advanced 1.2 percent in June, seasonally adjusted..."

Because food and energy prices are volatile and show large fluctuations month-to-month, most economists pay closest attention to the "core" Producer Price Index, which excludes food and energy. The "core" reading today was an increase of 0.7%.

Believe me, although there is widespread vicious antagonism and demented hatred toward the Federal Reserve and economists for their reliance on the use of "core readings," you'll want to think long and hard before hitching your cart to that strange tractor.

Trying to forecast inflation based on data that includes food and energy is like trying to judge how drunk you will be this evening by how much whiskey you had last night. It simply can't be done. There are too many competing factors involved, notably how much food you are going to eat today and how much energy you are willing to expend tonight in your efforts at intoxication.


4. The Three Stages of Processing

In addition to the headline and the core reading, the PPI breaks down price data based on the stages of processing: Finished Goods, Intermediate Goods and Crude Goods. Why? For one thing, this helps sort out where pricing pressure - or the lack of pricing power - are building in the so-called "pipeline," a fancy term for the many different stages of production - from obtaining the raw materials, to processing the raw materials, to products that are finally "finished" and ready for sale.

In today's PPI report, the Finished Goods PPI was up 1.2%. The Intermediate Goods PPI was up 2.7%. The Crude Goods PPI was up 4.2%. What does this mean? Think about it for a moment.

If the prices you receive for your finished goods are rising at 1.2% month-over-month, while the prices for intermediate and crude goods are rising at a faster level - as they have been for almost six consecutive years now - then that means you are finding it difficult to pass through price increases to your customers.

Below is a chart showing the spread between the Crude Goods PPI and the Finished Goods PPI.

The important thing to take away from this from a forecasting sense is the implied deflationary pressures that continue to build. The spread is now at its greatest point, a new high, which means that despite the "inflation" in the headline, there is an inability to pass through costs. Marry that inability to pass through costs with ongoing housing price deflation, the balance sheet restructuring going on with banks, the reduction in credit availability to both Wall Street and Main Street and you can begin to understand how the obsessive focus on inflation is like a weird obsessive focus on the sun setting in your rear view mirror while you drive straight over a cliff.


5. No One is Driving the Train

So you can see why all this talk about beasts is dangerous and disturbing, a sign the train is off the rails. A train derailment is an awful, unexpected tragedy. The parallel lines of the steel track run strong and true, a geometrically precise mandate for containment. The feeling among those who have never seen the inside of a locomotive is that the things pretty much drive themselves.

Of course, nothing could be further from the truth. It takes skill to operate an 8,000 ton train at 45 mph, which reminds me of a chart I put together a little over a year ago, just before these Fed officials began using all their "powers" to rescue the financial sector and, by extension, the economy. To go from "well contained" to FEVERISH BEASTS in one year tells us all we need to know about who is driving this train. No one.


Click to enlarge

And here's the updated chart since:


CLICK IMAGE TO ENLARGE

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No positions in stocks mentioned.

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