November 29th, 2022

Beware Of The Inflation Mirage

After a decent start to the holiday shopping season, investors had to deal with bearish news coming out of China as widespread protests broke out against the nation’s zero-covid policies. As China clamps down on protesters, the markets back in the U.S. fear what that will do to the outlook for global growth.

For example, Apple (AAPL) is set to lose as many as 6 million new iPhones after workers at the iPhone’s largest manufacturing plant in China protested delayed bonus payments, and poor living conditions caused by China’s stringent Covid restrictions.

Meanwhile, the various Fed members are now saying the terminal rate (the rate at which the Fed will stop rate increases) may need to be adjusted to higher than 5%. There was at least one member of the Fed who came out saying the financial markets are underestimating the chances that policymakers will continue to be aggressive in raising interest rates.

While oddsmakers are calling for a 50 basis point hike in December, down from the 75 basis point hikes we’ve seen, it’s important to remember that a few years ago a 50-point hike was enough to spook the markets. And now we’ve found a way to normalize the hikes to the point where investors are rejoicing over getting a 50-point hike. We’re rejoicing over going from extreme hikes to really high hikes.

But there’s one thing that very few are talking about and that is the inflation mirage. What is it?

Continue reading below.

If you look at the Fed’s Core PCE inflation economic projections you can see that they are projecting it to drop from 4.5% to 3% next year.

But what happens if people become accustomed to paying a higher amount for goods? What happens to inflation if the producers’ index doesn’t change year over year?

Let’s use an example by looking at the cost of a dozen eggs. Instead of comparing the PCE number from this year to last, let’s look at how the price of eggs can adjust inflation readings.

For the first few years, the cost goes up but now look at the inflation percent when there’s no increase to the cost of the underlying item (2023). You’ve fixed your inflation problem, right? It’s showing a 0% increase from the previous year. PCE can stay relatively unchanged and still show a decrease in inflation over time.

My point is even if prices start to come down from here, we could get a false sense that inflation is better even though we could be looking at elevated prices from prior years. Meanwhile, consumers will quickly burn through any savings they’ve accumulated over the pandemic years.

To me, stagflation is a bigger risk right now. I mentioned in yesterday’s article that people are still spending the same amount of money on holiday shopping, but the average number of gifts consumers purchase went down.

People are finding a way to spend the same amount of money, but they are getting less in return. There are so many stories about the looming recession, but yet consumers haven’t slowed their spending (yet).

Looking at our example again, what if consumers are still buying eggs despite the increase in prices? If all else stays equal, why would the egg producers lower their prices? They won’t. The PCE could then show price increases are slowing from the prior year, therefore inflation looks like it’s under control, but the consumer still has to pay high prices.

That’s when you get a period of stagflation, and that will ultimately hurt the markets all the way through 2023 and into 2024.

It’s not all doom and gloom right now. Here’s the SPY and we could be seeing a normal pullback from here. The next level of support is $390.

The three indices (SPY, DIA, QQQ) are above their respective 20-day exponential moving average as well as their 50-day simple moving average, indicating that the near-term trend is still positive.

Our trade idea for the day is in the Energy sector and it is BP p.l.c. (BP).

The current price is $34.73. Selling the December 30th $34 put would bring in $87 of income on a risk of $3,317.65. The $34 strike price is just over 2% away from the current price so there’s room for the underlying to move.

If the stock is above $34 by expiration, you would get to keep the $87, which would be a return of 2.6% in 5 weeks or just over 27% annualized.

If the stock falls under $34 and you don’t buy back the put, you would be forced to purchase 100 shares at $34, but your cost basis would be $33.13 and you’d own a stock that is in one of the strongest sectors of the year.

If you have any questions, comments, or anything we can help with, reach us at any time.
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Jeff Wood

Editor, Filthy Rich Dirt Poor

Trader, Options Testing Lab