How inflation affects your portfolio...
Thursday, February 28, 2008 | Jason Jovine
This is an important week on the economic front. The Federal Reserve is in a pickle. Its goal is to grow the economy and to keep inflation in check. I give it a “D” grade on both of these fronts.
I give it a “D” because the economy is doing poorly, mostly because of the lack of oversight on the housing front and the subsequent credit crunch that has ensued. This has hurt the economy in many ways.
GDP (Gross Domestic Product) for the 4th quarter of 2007 is expected to come in today up .7%. Recession fears exist for this year. On monetary policy front, the Fed has been cutting rates (rates now stand at 3%). On the Fiscal policy front, there are checks that are in the process of being sent out to you from the U.S. Treasury to help stimulate the economy.
This is too little too late. Now stagflation fears are present. Stagflation is low or no economic growth coupled with a high rate of inflation and unemployment. This is a nightmare for the Fed and for the economy.
As far as inflation is concerned, let’s take a look at the most recent PPI (Producer Price Index) numbers released on Tuesday:
As you can see from the RED circle above, PPI (for finished goods) in January was up 1%. From the GREEN circle, you can see that core PPI (for finished goods), which is the PPI excluding food and fuel, was up .4%.
The PPI measures the changes in prices that manufacturers and wholesalers pay for goods during the various stages of production.
There exist price indexes for each of the three progressive stages of production: crude goods, intermediate goods, and finished goods.
The crude goods index represents the cost of raw materials entering the market for the first time (e.g. coal, cattle, etc). As you can see from the BLUE circle above, the crude goods index rose 2.5% in January.
The intermediate goods index reflects the cost of commodities that have undergone transitional processing before becoming the final product (e.g. auto parts, leather, etc). As you can see from the BLACK circle above, the intermediate goods index rose 1.4% in January.
PPI and the CPI are, of course, linked. If prices become more expensive for companies, then they will eventually become more expensive for consumers.
The PPI and CPI are linked, but, unlike the CPI, the PPI does not take into account services. This means that over the short term the two don’t move in tandem, but over the long term they do.
How will this statistic affect stocks?
When the PPI goes up, the earnings of a company will generally go down. Some companies are, of course, affected more than others depending on their cost structure, etc..
Some stock investors may say that a little bit of inflation is good as it allows producers to charge more for goods which will increase revenues. The key question is: how much inflation is good?
Let look at a basic hypothetical example:
Joey’s Pizzeria (located in Queens, New York)
Revenue: $100,000
Cost: $60,000
Cost Breakdown:
$40,000 for employee’s salaries
$10,000 for inputs (dough, sauce, fuel etc)
$10,000 for rent
Profit (Revenue-cost) = $40,000
Now, say that Joey’s costs go up by 5%. This will bring his total costs up to $63,000 (1.05x$60,000). This will leave his profit now at $37,000.
This is just the start. As costs go up for Joey’s, less money is left to reinvest in the business or to pay out to the owners of the business (e.g. Joey).
Joey may raise the price of his pizza to offset the increase in his costs, causing an increase in the price for his customers (e.g. an increase in the CPI).
Joey is not the only one out there experiencing these increase costs. Other businesses are feeling the pinch as well, not to mention Joey’s employees. Joey’s employees may soon ask for a raise.
This becomes a vicious cycle. If Joey’s increases its prices to offset the increased cost too much, then he may lose customers and decrease sales and revenues. If he increases prices the right amount, his customers may tolerate it (especially if he has good pizza).
Let’s extrapolate this to a publicly traded company. If costs go up, the revenue goes down. This leaves less money to pay the owners of the company (e.g. the stockholders). The market is an anticipatory vehicle, and will value the stock based on future earnings.
The price of the stock will go down as Wall Street expects lower revenue.
What can you do during this inflationary time to protect yourself?
Ask yourself which companies are in the best position to increase the prices of their goods and/or services when their costs go up without losing business. These are the companies that hold up best during inflationary times.
Until the next time folks; spend your hard earned money wisely.
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Jason Jovine
Chief Investment Officer
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