How the “Bullwhip Effect” Just Saved Stocks

The July Consumer Price Index (CPI) has arrived and bulls couldn’t be happier. Headline inflation rose 0% month-over-month (vs. +0.2% expected), dragging down July’s year-over-year (YoY) gain to 8.5% (vs. 8.7% expected).

Core inflation, which excludes food and energy, remained flat at +5.9% YoY vs. the month prior. Analysts expected a rise to +6.1% YoY by comparison. This was arguably a bigger deal than the headline number as the Fed has historically watched core more closely than headline. The recent oil crash telegraphed a significant drop in gas prices, which fell 11% last month, dragging the headline number lower.

The real surprise was that core inflation also moderated. But it was something we actually predicted back in late June when retailers started to issue profit warnings while slashing prices on certain types of goods.

And it’s all thanks to something called “the bullwhip effect.”

The bullwhip effect is essentially an economic chain reaction, which occurs when there are changes in demand at the end of a supply chain. This causes inventory adjustments at the beginning of the supply chain that can mushroom into much larger disconnects between inventory and demand the further down the supply chain you go.

Because of these discrepancies, each link in the supply chain can then end up buying too few or too many items. Items go out of stock, get placed on backorder, or have their prices altered dramatically (upward or downward), sometimes all at once.

In April and May, inventories fell to multi-decade lows at US retailers. Demand remained relatively high, leading to stockouts among several different categories of goods and driving prices through the roof.

In late June-heading-into-July, though, inventory and demand flipped. Retailers loaded up on inventory to meet demand but did so too late. Demand then waned on many goods, leading to a glut of “general merchandise” – the term used by Walmart and Target to describe these goods – wasting away on store shelves. Target announced in late June that it would begin marking down unwanted items to make way for more in-demand merchandise starting in early July.

Lo and behold, the bullwhip effect was clearly visible in the July CPI data. The only core inflation price category that saw deflation (outside of used cars and transportation services) was apparel, which certainly is included under the umbrella of “general merchandise.” Apparel prices fell 0.1% month-over-month.

And that trend is likely to continue.

What won’t persist, however, is tumbling gas prices. Oil is likely to recover after plummeting through June and July, eventually leading to a headline CPI blitz toward the end of the year when gas prices catch up to rising oil. Food prices were up 1.1% month-over-month in July, too, beating June’s monthly gain of 1.0%. Investors should expect headline inflation to make a comeback as a result of this.

But core inflation could stay suppressed as the US economy battles a recession and the bullwhip effect keeps a lid on general merchandise. Rising oil and food prices should suppress core inflation also as Americans are forced to choose between feeding their families and flatscreen TVs.

For stocks, though, that’s not going to matter in the short term. The June highs have been breached and bears are going to have to start covering their shorts. Once they do, the major indexes could easily short squeeze higher, pushing the ongoing bear market rally even further.


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