The Potential Profits Squeeze

"Don’t fight the Fed” is an old stock market adage. Successful investors pay a lot of attention to it. It means that when the central bank is easy, it’s bullish for stocks. And when the bank turns tight, it’s bearish for stocks.

Obviously, the Bernanke Fed has been ultra-easy for a couple of years now: The bullish stock market has just doubled its value from the early March 2009 bottom.

However, another old stock market slogan is “follow profits.” Profits are the mother’s milk of stocks, and they have been doing very well over the past two-year market rally. So don’t fight profits, either.

But some new information raises a question mark about the longevity of rising profits. Namely, producer prices— which used to be called wholesale prices—are now rising much faster than consumer prices.

In other words, if the input costs for a company are rising more than the prices it gets at final sale, that’s gonna squeeze earnings. And that’s exactly what’s happening now, even though the ebullient stock market seems to be ignoring it.

The January report on producer prices showed a third-straight outsized increase, summing to 9.6 percent at an annual rate. Over the past 12 months, PPI is up 3.6 percent. Behind these big jumps is the import-price index, which just increased above 5 percent year-on-year for the second-straight month.

The unreliable dollar has something to do with it. As the Fed keeps printing new greenbacks, both real and nominal broad-dollar indexes measured by the Fed are showing nearly four-decade lows. And of course, commodity indexes have been exploding. You might say there’s too much money chasing too few goods and assets at home and around the world.

But on the potential profits squeeze, consumer prices through December (we get a new January CPI tomorrow) are rising at a 1.5 percent rate -- 2.1 percentage points less than the PPI. That erodes profit margins. This is a profits warning and a yellow flag for the stock market.

Incidentally, speaking of the CPI, there is an important consumer-goods component of the PPI. Overall consumer-goods prices are up 12.2 percent annually over the past three months and 4.7 percent over the past year. Even the core ex-food-and-energy part of consumer goods is rising 4.8 percent annually over the past three months.

So the combination of easy money, a cheap dollar, and rising commodity and import prices, along with the fact that wholesale prices are gaining much faster than consumer prices, should provide a sober reminder that this big stock market rally is not completely glitch free.

Finally, in the most recent Fed policy minutes released today, the central bank acknowledges a more optimistic economic-growth story. It has raised its 2011 forecast to a range of 3.4 to 3.9 percent, up from its earlier band of 3.0 to 3.6 percent. But it remains unconcerned about inflation. So as far as QE2 goes, expect the Fed to keep on pumping.

Which brings me back to that old adage, “don’t fight the Fed.” Sure, the Fed is your friend. That is, until it’s no longer your friend. There is such a thing as the law of unintended consequences.