The Market Just Got a Huge Warning Sign

0:02Travis Hoium:Inflation is back and Motley Fool Hidden Gems Investing starts now.

0:09Travis Hoium:Welcome to Motley Fool Hidden Gems Investing. I'm Travis Hoium joined today by Rachel Warren and our substitute for Lou Whiteman, Tyler Crowe. Guys, we're going to talk a lot about inflation today. And before you think that this is going to be a boring episode, we're going to tie this to what this means to investing because inflation is not all that fun. I don't like it when prices go up. I don't think anybody really does, but it really matters to what's going to happen to the market. So we're going to try to piece all this together. The thing that came out earlier this week, we'll get to PPI in just a second, but CPI came out earlier this week.

0:46Travis Hoium:That's the consumer price index. This is what you and I feel when we go to the grocery store, we fill up our gas tank. Like inflation, Rachel, was 3.8 % in the month of April. That was hotter than expected and much higher than the kind of 2 % or 3 % that the Fed would like inflation to be at. And things are really picking up. Energy prices were up 6.1%. Vehicle maintenance is up. Food is up. That's the stuff that we feel as consumers. So what stuck out to you in the data and kind of how do you wrap your head around it? Well, that headline number's up a bit from 3.3 % in March. It's the highest annual rate we're seeing since May of 2023.

1:29That spiked, though, as you noted. It's being heavily fueled by, we saw an energy index surge of 17.9 % over the last 12 months. Energy commodities spiked 29.2%. Gas prices up 28.4%. Fuel oil rising 54.3%. Core inflation, right? So excluding volatile food and energy costs also accelerated to 2.8 % annually, hitting a monthly increase of 0.4%. But consumers are seeing price hikes in everyday categories, right? You know, electricity costs, motor vehicle maintenance, airline fares. Obviously, the really immediate ramifications are the squeeze on the consumer. I mean, we're seeing inflation outpace annual wage growth for the first time in three years.

2:11That actually drove real inflation-adjusted hourly earnings down by 0.3 percent based on this recent readout. Now, there's been some speculation that this could maybe alter the Fed's playbook, right? We're seeing fixed income markets are kind of adjusting to this higher-for-longer rate environment. You've got some analysts floating the possibility of a rate hike. But I think ultimately we're seeing a reality where there's this prolonged gap between sticky inflation, we're seeing low-yielding traditional bank accounts, means that cash reserves might rapidly lose their purchasing power. So there are a lot of first and second order impacts on consumers.

2:46And it's something that's not just going to go away, even if the current conflict that we're seeing that's driving some of these price hikes is to abate in the next two, three weeks.

2:56Travis Hoium:Tyler one of the interesting things is the market does not really seem to care that the CPI is going up in particular and one of the pushbacks I always get when I post about this is hey as long as the hyperscalers continue to spend a trillion dollars plus or minus on building out this AI infrastructure who cares if bananas are a little bit more expensive or it costs you know a little bit more to fill your gas tank. there's a little bit of truth to that but it also seems like it's a little worrying under the surface

3:26Tyler Crowe:yeah and this is not just something that we're seeing in these numbers right now it's kind of been bubbling under the surface because like we said the market's rallying s &p 500 as we'll call a representative sample of the entire market is doing well i mean it's up eight percent this year then accident 100's up 16 but if you start to like look down into the components there is really like a have and have nots aspect to this, mostly related to AI infrastructure spending and kind of that, all the trickle down effects when you get into that. Because right now, only 52 % of the stocks in the S &P 500 are now above their 50 day moving average, which basically means you have a almost half, 48 % of them are basically like trending down and probably headed down further in the sense of like consumer spending.

4:15Tyler Crowe:We're seeing margins compression, we're seeing lack of sales. We discussed this a little bit yesterday, Travis, talking about consumer good stocks like Nike, where we're seeing having to go to discounting and things like that to drive sales, but it's also just leading to margin pressure for them. And that's also because consumers are feeling it as well on these particular companies. In the strange sense of yeah, from the wallet perspective, we feel what's going on with inflation, but the market doesn't seem to care because you have this weird place of like AI infrastructure spending with these gigantic companies that are either spending on the cash on hand or spending it on from cash from operations where they don't have to take on debt.

5:02Tyler Crowe:They're not worried too much about inflation rates or anything like that because it's not like there's going to be long-term consequences to what they're doing.

5:11Travis Hoium:Yeah, it is a really interesting dynamic. The other thing is that we have not seen a huge impact on the labor market, at least from an unemployment perspective. Rachel pointed out that wages are not keeping up with inflation, at least in the last few months. That could end up being an issue, but we haven't seen those layoffs because of AI yet. So maybe things change if that comes to the fore. When we come back, we are going to get to PPI and what those numbers look like. You're listening to Motley Fool, Hidden Gems Investing. Thank you.

6:13Travis Hoium:Welcome back to Motley Fool, Hidden Gems Investing. PPI, or the Producer Price Index, also came out this morning as we're recording. And that was even more shocking when I saw those numbers. Tyler, prices were up 1.4 % in the month of April. That was from a month ago. That was not the year-over-year. That was the month-over-month number. Year-over-year was up 6%. Energy was up. Food was up. Services are up. this seems like it's only going to make that CPI number that we talked about in the first segment worse, but we haven't quite even seen this flow through yet.

6:51Tyler Crowe:PPI, we could say, is the leading indicator of CPI because it's higher up the supply chain, you know, your distributors, your manufacturers that are going to add value and then finally get it to the customer eventually. This is where they're seeing the pricing pressure from a lot of things that we were just talking about. You have basically this supply bottleneck. talking about AI hyperscaler infrastructure spending. It feels like every discussion we have these days comes back in some way or another to AI infrastructure spending because it's so large. But you look at a lot of suppliers in these industries, they're looking at book-to-bill ratios where the amount of orders coming in the door is 70 % more than the equipment that they're shipping out in any given month, backlogs for stuff multiple years.

7:40Tyler Crowe:And so the equipment that they're having to produce and supplies they're producing, having to bring in the door are going way up. So you have this bottleneck of basically companies that cannot make things fast enough to get out the door. That's driving up prices. And then on the original raw material side, we have the closure of straighter huboos. You want to call it the war, the conflict, Like whatever term you want to put to what is happening, it's just basically the closure of the Strait of Hormuz has wider implications. We're not just talking about oil and gas here and refined products. This is a part of the world that exports 10 to 20 % of the world's aluminum, 20 to 30 % of the world's fertilizer, 30 to 40 % of the world's helium, which sounds kind of weird.

8:28Tyler Crowe:I'm not talking about balloons. I'm talking about like semiconductors and medical imaging. These are the sort of things that matter when we're talking about.

8:34Travis Hoium:These are the weird disruptions that we had during the pandemic that we didn't realize were going to have a huge impact. But it's some, you know, small product that ends up kind of breaking the supply chain.

8:44Tyler Crowe:Yeah. And we're getting to the point now where these things are really starting to bleed through because, you know, a couple of weeks, everyone, we all, you know, started pulling at our hair and thought the world was on fire. It was like, but we started to get through, but it's now been like seven or eight weeks. and now we're looking at actual shortages the u.s has been drawing down this retreat petroleum reserve inventories have been dropping worldwide we're already starting to see like european curtailment of flights is already in the i think it was like they said two million passenger range in the in this month alone that there's a lot of things where we're starting to see the tightening of the markets to the point where we're seeing very high rising prices because we're just in short supply of things.

9:27Tyler Crowe:And it's hard to see that changing anytime soon. Yeah.

9:31Travis Hoium:Rachel, I want to add commodities into this. Tyler kind of alluded to this, but some of these numbers, if you look at the year over year changes are absolutely crazy. Crude oil, we know that's up a little over 60%. Gasoline up 71%. But if we go to something like metals, silver is up 170%. Lithium, you know, lithium ion batteries up over 200%. You go to food, wheat is up 27%. That's a smaller number, but that's actually making its way into those food prices that we talked about earlier. Wool up 58%. This is not the same as a year ago when we were talking about inflation because there was going to be tariffs.

10:10Travis Hoium:Tariffs, you could go, well, it's a little bit of take money from your left pocket and put it in your right pocket. Maybe there's a little bit of a jobs benefit for the US economy. If those jobs are being pulled back, you can kind of move things around. It's much harder to move things around when your core raw materials are going up in price astronomically. And we'll talk about companies in just a second, but this is going across the supply chain to things like memory and chips and all kinds of stuff. So this seems like something we really need to keep an eye on. Yeah, I mean, the reverberations are basically across every sector you can think of.

10:43And that's why PPI is so important. It acts as this very key indicator of inflation, it tracks price fluctuations before they ever reach consumers. So you kind of think of it as the early warning system for consumers, right? Consumer price index tracks what you and I pay at the register, but the producer price index, or PPI, tracks inflation to the factory floor. So what businesses are paying for raw materials, like you just mentioned, fuel, wholesale supplies before those products ever reach a store shelf. And we are seeing astronomical spikes in the cost of energy to run factories, food ingredients for packaging and just the baseline services required to ship goods.

11:20And so if you're looking at this as an investor or as an everyday consumer, this is a look into the immediate future and what it spells for a lot of these different costs. And the important thing to note is when the costs of making a product explode this quickly, most businesses can't afford to just absorb the financial hit. And so obviously to protect their margins, they are going to eventually pass that down to the consumer. And I do think if you're looking at this today, it is a bit of a preview of what we're going to be seeing in terms of price hikes on grocery shelves, retail websites at the gas pump.

11:53I think it also underscores the fact that as robust as the stock market's performance continues to be, there is and remains a fundamental disconnect between the realized economic reality for a lot of consumers. And that's also important to us as investors for a lot of the companies that we own and follow.

12:11Travis Hoium:You alluded to it, but we're going to try to tie all this together in the next segment and talk about what this means for us as investors in the market going forward. You're listening to Motley Fool, Hidden Gems, Investing.

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12:53Travis Hoium:Welcome back to Motley Fool, Hidden Gems Investing. All right. So we've talked about CPI, we've talked about PPI. Now, what does this actually mean to the bottom line and to our investments? So we know that consumers are getting more stretched. Some costs are going up. I've been hearing a lot more reports about supply chains being stretched. Apple are still undersupplied with iPhones. They're maybe not making as many Macs as they would like or could sell because of chip shortages and memory costs are going up. So maybe margins get squeezed. You have companies like Target, Walmart, Costco. They're the consumer touchpoint.

13:32Travis Hoium:Some of those stocks are extremely highly valued, 40, 50 times earnings. So, Rachel, with all of this backdrop of inflation, of kind of this tenuous position that consumers are in, but yet we're still investing a ton in artificial intelligence, where are you looking at risks and opportunities for investors? Yeah, I mean, I think there are risks and opportunities across a range of markets. One of the things that's kind of interesting to consider is the subscription models for services like Netflix and Spotify, right? I mean, these are services that tend to be billed on recurring monthly cycles.

14:04So historically, there's kind of this level of baseline consistency. But what we'll often see in these, you know, maybe difficult macro periods is maybe instead of a user maintaining three or four active streaming subscriptions, they'll have a cyclical pattern. Maybe they'll subscribe, say, to Netflix for a single season of a show, and then they'll cancel, especially during these periods of economic pressure. So I think that's something that could be a risk to what I think are fundamentally great businesses like Netflix and Spotify. You talked a bit about the retailers, right? So Target's an interesting example.

14:35They rely really heavily on home decor and apparel sales. So there's, I think, a much broader exposure to non-essential spending. Whereas you have Walmart, right? They have about 60 % of their U.S. sales come from grocery sales and household staples. One other example, you think of a premium operator like Costco. They make most of their profits from their membership-based model. That's given them pretty predictable cash flows as well during past volatile periods. I'm not saying necessarily go out and buy Walmart and Costco, but I do think it's important to understand where the resilient businesses are and how those cyclical elements trickle down overall.

15:14Travis Hoium:Yeah, Tyler, how do you think about this cyclicality? Because it does seem like, man, when prices go up like this, the last time this happened was, you know, 2021 going into 2022. The market was not real happy at a certain point, but it took a little while to get to that point where the market went, oh my gosh, this is a problem.

15:32Tyler Crowe:At least to a degree, there's, I think, maybe a little bit more expectation this could be coming because also in 2022, the thing that we had coinciding with it was 0 % interest rates for a while and then all of a sudden we're like oh man we really need to change course here uh we're already i think what the uh the federal fund rates is three and a half 3.75 so there's already some built in like inflate or interest rate sort of but i think the expectation has been

16:00Travis Hoium:that we were going to lower those rates and maybe now we may be moving to a point where we're the expectation is we're going to have to raise those rates that seems to be where the market kind of goes, oh my gosh, we got to raise our discount rate and then valuations start to fall because those rate expectations change. Yeah.

16:17Tyler Crowe:I think that's, it's a fair thing. And when it comes to valuation, perhaps there's, I don't know, I feel like there's a lot of more growth oriented people that are maybe, you know, throwing valuation to the wayside these days, perhaps to my chagrin and why some of the stuff I've been buying has not been doing as well. But when I'm thinking about this specifically in like the consumer spending inflation going up budgets tightening i'm actually the thing that i'm most thinking is like at risk is like the middle market stuff uh not not the discretionary the walmarts the costcos of the world or the top end it's that that stuff sort of in the middle and this is and here's why i'm coming at it from this way i don't think it's any secret.

17:03Tyler Crowe:There's been reports all over. 50 % of consumer spending these days is from the top 10 % of earners in the United States. And so in that regard, a lot of those things where you see discretionary spending on the higher end things might not change that much. I mean, take airlines, for example. We have been talking about higher gas prices, and one of the biggest causes of inflation was airline tickets. And yet over the past couple of weeks where we saw airlines give guidance for 2026, all of them raised earnings guidance. And they were saying like, we're booked up. This is things are looking really good.

17:41Tyler Crowe:It's, it's, it's, you know, maybe when international flights start to get canceled because of, uh, we'll see a change in heart there, but like for right now, the well off are basically, you know, propping up a lot of spending in that regard. And then back to the essentials, you have the Walmarts, the Costcos of the world. It's hard to see them really suffering as a result. Maybe some of the mix on products is different. But what I'm thinking is things in the middle, fast casual restaurants, athletic wear, cosmetics, automotive, things where people across all income spectrums are paying up to do, but aren't necessarily like the things that you have to do in any given day.

18:21Tyler Crowe:Like we said, yesterday's show, we were talking about the athletic wear sort of market. And unsurprisingly, the company that we pointed out is doing the best was On Holdings. Again, very much on the upper end, targeting that higher spending demographic relative to everyone else in their industry who are not doing quite as well. And so if you're looking at risk of the consumer, I think it's that real middle market area of the Chipotles of the world, the Cavas, the Nikes, things like that, where you're going to see the most impact on how people spend their money and likely to see the discounting, the struggle for sales, struggles with inventory, maybe some write downs and things like that, where at least from a business perspective, I think we're going to see the most effect.

19:10Tyler Crowe:And then valuation, I feel like we've been trying to guess what people think about valuations for 15, 20 years, and I've been getting it wrong every time anyways. So let's, we'll see.

19:23Travis Hoium:The one thing that I want to add is this is a kind of point in the market where I'm looking very closely at one valuations, but balance sheets, because whether this current point is, you know, the peak in 2021, whether it's, you know, we're going into 2008, 2009, whether it's a, you know, dot-com is the, or AI is the new dot-com bubble. We don't know what that future looks like, but the companies that have really good balance sheets have some sort of differentiation, pricing power, they're going to be able to survive whatever comes next, whether that's good or bad. And so these, these fluctuations in inflation and things like that maybe aren't necessarily the same impacts for those stronger companies.

20:01Travis Hoium:So that's just one thing I want to flag for investors is there's a lot of uncertainty out there. I have more questions than answers, but I think Lou's K-shaped economy is exactly what Tyler was talking about. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. All personal finance content follows The Motley Fool's editorial standards and is not approved by advertisers. Advertisements are sponsored content and provided for informational purposes only.

20:30Travis Hoium:To see our full advertising disclosure, please check out our show notes. For Tyler Crowe, Rachel Warren, and Dan Boyd Behind the Glass, I'm Travis Hoyam. Thanks for listening. We'll see you here tomorrow.