PPI and the Stock Market

Inflation at the producer level (derived from the Producer Price Index – PPI) is logically an advance indicator for inflation downstream at the consumer level (derived from the Consumer Price Index – CPI). Do investors therefore reliably react to changes in PPI as an indicator of the future wealth discount rate? In other words, is a high (low) producer-level inflation rate bad (good) for the stock market? Using monthly historical PPI data (for finished goods, seasonally adjusted) from the Bureau of Labor Statistics (BLS) and contemporaneous S&P 500 Index data as available from January 1950 through October 2010 (730 months), we find that:

The following chart shows PPI and the S&P 500 Index over the entire sample period. While both indexes tend to rise over time, visual inspection reveals no systematic relationship between the two series. The rapid increase in PPI during the 1970s does appear to be bad for stocks.

For a closer look, we compare monthly changes in PPI to monthly S&P 500 Index returns.

The following scatter plot relates next-month S&P 500 Index returns to monthly changes in PPI over the entire sample period. The Pearson correlation for the two series is  -0.05 and the R-squared statistic is 0.00, indicating that PPI explains hardly any of next-month stock market returns.

Might changes in PPI lead stock market returns at some horizon longer than a month?

The next chart summarizes correlations between monthly S&P 500 Index returns and monthly changes in PPI for various lead-lag relationships, ranging from stock returns lead PPI changes by six months (-6) to PPI changes lead stock returns by six months (6). Over these horizons, the lead-lag relationships are very weak and mostly negative.

In case the relationship is cumulative, we look at quarterly measurement intervals.

The next scatter plot relates next-quarter S&P 500 Index returns to quarterly changes in PPI over the entire sample period (243 quarters). The Pearson correlation for the two series is  -0.02 and the R-squared statistic is 0.00, indicating that PPI explains hardly any of next-quarter stock market returns.

In case there is a material non-linearity in the relationship, we look at average stock market returns by range of quarterly change in PPI.

The next chart shows the average next-quarter returns for the S&P 500 Index by quintile of quarterly change in PPI over the entire sample period. While the lack of systematic progression across quintiles undermines belief in an overall relationship, the average stock market return after the lowest fifth of PPI readings is notably strong. This result is robust to omission of the two best quarters for stocks within this quintile.

Might PPI lead stocks by more than one quarter?

The next chart summarizes correlations between quarterly S&P 500 Index returns and quarterly  changes in PPI for various lead-lag relationships, ranging from stock returns lead PPI changes by four quarters (-4) to PPI changes lead stock returns by four quarters (4). Over these horizons, the lead-lag relationships are weak and mostly negative. Results suggest that PPI increases are somewhat bad for the stock market over the ensuing year.

Reservations regarding the above results are:

• Analyses are in-sample. An investor operating in real time would not have access to data for the entire sample period.
• Since PPI releases occur after the end of the month by roughly two weeks, there is some offset between PPI changes and stock market returns as calculated above. This offset could affect the statistics.

Do PPI releases present short-term trading opportunities?

The next chart shows the average daily S&P 500 Index returns from three days before (-3) through three days after (3) PPI release dates since 1994 (200 events, excluding September 2001 due to interruption of stock trading), with one standard deviation variability ranges. Day 0 is the release date, with release before normal trading hours.

The mean daily return for all days during the sample period is 0.03%. The event pattern suggests that investors may have a tiny bit of excess worry just before release date and a little bit more relief after release date. However, the deviations from the average return for all days are very small compared to daily variability.

Do event returns vary with the nature of the PPI news?

The final chart compares the average daily S&P 500 Index returns from three days before through three days after PPI release dates since 1994 for three ranges of change in PPI. The worst (best) average returns follow the biggest increases (least extreme changes) in PPI. Subsample size is 67 events. What anticipation there is (day before release) appears to be mostly contrarian. However, the magnitudes of all the average daily returns are problematically small from a trading perspective.

Note that BLS frequently releases new Consumer Price Index (CPI) index data within three trading days of PPI releases, potentially confounding interpretation of results.

See “Economic Announcements and VIX” for the behavior of implied volatility (VIX) on PPI release dates (which may offer better trading opportunities).

In summary, PPI is not a reliable signal for either short-term or intermediate-term trading of the broad U.S. stock market.

This analysis does not rule out the possibility that surprises in PPI, relative to some measurable expectation, more usefully forecast short-term or intermediate-term stock market returns than indicated above.

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