WAL MART AND HOME DEPOT PLUNGE ON WEAK HOUSING AND HIGH ENERGY PRICES -- THAT'S WHY IT'S DANGEROUS TO EXCLUDE ENERGY FROM INFLATION -- COLLAPSE IN CONSUMER DISCRETIONARY SECTOR HINTS AT WEAKER CONSUMER SPENDING

PRODUCER INFLATION WAS UP -- NOT DOWN AS REPORTED ... One of the major newswires reported this morning that inflation at the producer level came in lower than expected during July. The article was referring to the "core inflation" number (excluding food and energy) which was 0.1% (lower than economist forecasts for 0.2%). One economist stated on the radio that the low inflation reading would give the Fed more to ease. The problem is that the actual PPI number was 0.6% (more than three times economists' forecasts of 0.2%). The article I read didn't even mention the higher number. Just a month ago, the Fed chairman complained before Congress that the problem wasn't inflation itself, but the public's "perception" of inflation. He complained that people see inflation where the Fed doesn't. It's pretty easy to see why. People experience inflation in food and energy, while the Fed excludes them from its calculations. I would suggest that it's the Fed that has a perception problem. The danger of igoring high energy prices was brought home today by price tumbles in two of the biggest retail chains -- Wal Mart and Home Depot. Wal Mart cited high energy costs as one of the factors keeping consumers from spending more. If higher energy prices are such an important factor in consumer spending, how can the Fed justify not counting it in its inflation figures? Wal Mart also suggested that the housing slump would keep consumers from spending. I've made that same claim several times (including yesterday). Strange that economists and the Fed don't see that. Then again, all Fed members are also economists.

Chart 1

HOME DEPOT TIED TO WEAK HOUSING ... That headline is taken directly from my May 15 message. So is Chart 2. The chart is meant to show the close correlation between Home Depot (black bars) and the Housing Index (brown line). The link between the two is unmistakeble. The actual slide in both lines started in the spring of 2006 (see arrow) and has continued since then. The Housing Index has since fallen to the lowest level in four years, while Home Depot has just dropped to a new 11-month low. I wrote on May 15 that "It looks like the housing index is leading the home improvement stock lower". It still does.

Chart 2

WALMART FALLS 5% ON HUGE VOLUME ... Wal Mart fell 5% this morning on heavy volume, putting the stock at a new 11-month low. The monthly bars in Chart 3 show the stock heading down toward its 2005-2006 lows in the low 40s. The pink line in Chart 3 is a relative strength ratio of Wal Mart versus the S&P 500. The line has been dropping since 2003. Chart 4 suggests one of the reasons why. That chart overlays the WMT/S&P ratio (pink line) on the price of crude oil (black line). The chart shows that Wal Mart's poor relative performance started just as crude oil started rising four years ago (See arrows). It's hard to dispute Wal Mart's claim this morning that high gasoline prices have discouraged consumers from driving to its stores. Not surprisingly, Retail Holders fell more than 2% today and are the day's weakest ETF. The RTH has fallen to the lowest level in four months. Yesterday I showed it also trading well below its 200-day moving average. It just so happens that Wal Mart and Home Depot are its two biggest holdings.

Chart 3

Chart 4

CONSUMER DISCRETIONARY SPDR TUMBLES TO NEW LOW... Weak retailers and homebuilders are combining to make the Consumer Discretionary SPDR (XLY) the day's weakest sector. The daily bars in Chart 5 show the XLY falling to its lowest level since last September. The XLY broke its 200-day line nearly a month ago. Even more disturbing is the collapse in its relative strength ratio (solid line). That line peaked in January and has been collapsing since then. If the breakdown in consumer discretionary stocks is any indication of the direction of consumer spending, I'll leave it up to you to decide which way both are heading.

Chart 5

S&P 500 IS TRADING BELOW 200-DAY AVERAGE ... The market appears headed toward another bad chart day. Most of the major stock indexes are down more than 1%. Big board decliners are outpacing gainers by a 3-1 margin (2-1 on the Nasdaq). Of more importance is the fact that the S&P 500 (and the NYSE Composite Index) are trading back below their 200-day averages (Chart 6). The Nasdaq Composite is headed for a test of its 200-day line (Chart 7). That puts the market at a critical spot. Treasury bonds are rallying in a continuing flight to safety. Two other markets that are rising are the Japanese yen and the CBOE Volatility (VIX) Index. None of those are positive for the market. Today's price and volume figures should tell an important story. MORE AFTER THE CLOSE.

Chart 6

Chart 7