Stocks calm amid deflation, threats to corporate profit

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Stocks finished mixed again on Thursday in another quiet session. I checked the calendar, because the action feels eerily like a holiday reprieve. Where is everyone?

Or maybe like a calm before a storm given threatening data on nascent deflation and a rollover in corporate earnings. I know it’s almost forbidden to say this out loud with sentiment so bubbly — just look at the action in Apple Inc. (NASDAQ:AAPL) or biotech stocks lately — but things are looking recession-y on these measures.

In the end, the Dow Jones Industrial Average lost 0.1%, the S&P 500 lost 0.1%, the Nasdaq Composite gained 0.4%, and the Russell 2000 gained 0.3%. Stocks, broadly speaking, are hitting resistance from the long trading range going back to July.

At the sector level, tech led the way with a 0.7% gain — helped by a 1.3% rise in AAPL stock — while energy shares dropped 1.8%. Crude oil fell nearly 4% to close at $48.97. That boosted the ProShares UltraShort Crude Oil (NYSEARCA:SCO) I recommended to Edgesubscribers last week to a gain of 14.3%.

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The government on Thursday reported that the Consumer Price Index dropped 0.2% in January from the year-ago period, led by a 9.7% month-over-month decline in energy prices. Gasoline prices fell 18.7% last month. This is the first outright decline in prices since Lehman Brothers blew up.

As Japan’s nearly two decade economic downturn shows, deflation can smother growth for years. Falling prices encourage consumers to wait for even lower prices, stifling sales and pushing down wages, making it harder for households and business to service their debt, which also becomes relatively more expensive.

For now, many economists, as well as the Federal Reserve, mostly discount the danger to the U.S. economy posed by deflation, which is now hindering Europe’s growth. Indeed, after removing the impact of volatile food and energy prices, so-called “core” CPI rose at a 1.6% annual rate. That’s low, but close to normal.

But the grave risks of deflation means some experts already sounding the alarm.

Societe Generale strategist Albert Edwards, known for his bearish bent, focused on the threat in a recent note to clients. He compares what’s happening in the U.S. to the deflationary environment in Europe, seeing symptoms of global economic slowdown.

The Fed, if it underestimates the threat, could make it worse by raising interest rates later this year. In her testimony to Congress this week, Fed Chair Janet Yellen said the central bank is “reasonably confident” that inflation will rebound. She pointed to the relative stability of measures of future inflation expectations, and explained away the recent collapse in bond yields — as bond traders demand less and less inflation compensation — as caused by other factors.

Maybe Yellen’s optimism will prove prescient, especially with lower inflation boosting real wages for consumers. But the data is worrisome, suggesting that the economy is weaker than it seems.

Further evidence of trouble comes from the rapid decline in forward earnings expectations, which as the chart above from Soc Gen’s Andrew Lapthorne illustrates, should pull down GDP growth in the months to come. Many have dismissed this out-of-hand as being caused by the rapid decline in crude oil prices pummeling the energy sector. And certainly, that’s a big part of the story.

But it’s not the whole story.

Weakness has been fairly broad based with consumer staples, materials, utilities and telecom sectors all seeing big drops in earnings expectations. The risk is that a stalling of earnings will force companies to scale back investment spending and hiring, which in turn, will stall the economy.

Plus, globally, the situation isn’t looking so hot according to Lapthorne. If it were, why have 20 central banks around the world cut interest rates in 2015? Why have economic surprises nosedived here in the United States while stock market multiples blow out? And why are most other countries — except Singapore, Ireland, and Japan — also seeing earnings downgrades?

Given all this, I maintain my skepticism focusing on the few opportunities on the short side with a focus on energy/materials as discussed here and here. The puts against the United States Oil Fund L.P. (ETF) (NYSEARCA:USO) that I recommended to Edge Pro subscribers on Feb. 18 are up nearly 80% while the Alcoa Inc (NYSE:AA) puts recommended earlier this week were trimmed for a 83% gain.

Anthony Mirhaydari is founder of the Edge and Edge Pro investment advisory newsletters.

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Stocks calm amid deflation, threats to corporate profit