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.