3/19/2010
By David Urani, Research Analyst

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This week, we got to peer into the environment for prices both on the producer and consumer side from the government's PPI (Producer Price Index) and CPI (Consumer Price Index) indexes. The headline number for CPI showed no change month to month in February, while the core reading (excluding food and energy) increased by 0.1%. It was an overall flat result, but looking deeper into the components, it was marked by falling energy prices offset by rising food prices. Apparel was another standout, falling by 0.7% month to month as retailers ramped up the discounts. There were similar item by item trends in the PPI report, with producers paying less for energy and more for food. For producers, however, a 2.9% drop in energy prices brought down the whole index to a 0.6% drop month to month.

Taking the two indexes into account, one could deduce that generally lower energy costs decreased the cost of production for most goods. Meanwhile, consumer prices were kept flat. Consequentially, it is likely that producers saw generally higher gross margins in the month of February versus January. We took the liberty of compiling the PPI and CPI indexes and then calculating the difference of CPI minus PPI to get what we call the "inflation spread." As you can see below, that spread correlates quite well with corporate operating earnings.

What can be learned from this? Well, looking at January and February, the inflation spreads for both months were lower than that of December. December's spread, in turn, was lower than those of October and November. Therefore, one could deduce that despite the higher spread between CPI and PPI in February versus January, overall the first quarter of this year is shaping up to be weaker than the fourth quarter for profit margins, and consequentially, earnings.

David Urani
Wall Street Strategies