Inflation Report Positive, Stocks Negative. . .

Today's producer price index (PPI) was meaningfully below expectations, more evidence that inflation has perhaps peaked or that at the very least, we've moved into a sustained period of inflation stability. Not surprisingly, bond investors were cheered by the news and we've seen a broad rally in the fixed income markets today. But the stock market isn't following. Indeed, at midday stocks are down. What gives?

In our view, one of the key determinants of stock prices is earnings. Simply put, stock prices follow earnings growth over time. So during periods of rising earnings such as we've seen the past few years, stocks do ok. However, periods of stable or falling earnings growth are generally bad for stocks. So what does this have to do with the PPI?

We just reviewed a report from Merrill Lynch which shows a very tight correlation between Core Crude PPI and the earnings of the S&P 500. A rising PPI equates to rising earnings growth, falling PPI results in falling earnings growth.

Perhaps today's good news on inflation is not such good news for the stock market.

More Positive News . . .

Today's inflation report, the CPI rising 0.2%, is further evidence of at the very least a temporary stabilization of inflation. We also note the continuing slide in gold and today's new 2006 low being made by crude oil as further vindication of the Fed's decision to leave short term interest rates unchanged. We suspect that the next Fed meeting will result in no action. This is good news for the financial markets and both stocks and bonds are up this morning as a result.

We think that the earnings reports that will start to filter in the next several weeks will be the key for a meaningful stock market advance. Pay particular attention to any statements regarding the outlook for the fourth quarter as positive comments should hold the key to driving prices higher.

In case you missed it, gold is heading south. . .

Take a close look at this chart on the right. It is a twelve month price chart of the streetTracks Gold etf (symbol: GLD) from BigCharts. A share of GLD is equal 1/10th of an ounce of gold and thus a great proxy for the metal itself. Of course, the price of gold is affected by a number of variables and is viewed by many as an inflation hedge. So it is very interesting to note that gold peaked in late spring and has been trending lower ever since. It now looks like GLD is breaking below its 200 day moving average (approx. $58.5) and starting a new leg down. What does it mean? Time will tell but we suspect GLD's breakdown reflects moderating inflation expectations and good news on interest rates. Watch out though, falling gold prices also reflect concerns of a slowing economy and the risk of a recession.

OUCH!! Unit Labor Costs Up 5%

This morning the Department of Labor reported that  second quarter unit labor costs rose 5% over the past year.  This is clearly not good news on the inflation front. Higher labor costs are ultimately passed through to consumers in the form of higher prices for goods and services (inflation!) or absorbed in the company's profit margins (lower earnings!).  Either way, this is not good news for stocks or bonds and we've seen markets sell off in pre-open trading today.

But don't give up hope.  There was some positive news in the release.  Most importantly, productivity improved in the second quarter increasing 1.6%.  Higher productivity helps to offset rising labor costs and keeps inflation pressures in check.

Summer's Over!

Today, Labor Day, marks the unofficial end of summer. With vacations coming to an end and the kids heading back to class, we can begin to look forward to the final quarter of the year. Of late, we have received relatively positive news on the economy with inflation stabilizing, energy prices falling, the Fed pausing, earnings growing and markets moving higher. We believe this favorable trend will remain in place for the balance of the year.

However, September has been a tough month for stocks in the past. The third calendar quarter (July, August, September) is notoriously difficult for companies and analysts to forecast. People go on vacation, severe weather can have a major impact (as it did last year) and there is a tendency to push for a strong fourth quarter at the expense of a quiet third. Thus the chances of nasty earnings surprises and market volatility are high. So as the earnings reports come in, we'll be looking for evidence of sustained growth in the fourth quarter and next year to confirm our positive view of the markets.

Happy Labor Day!