Jim Paulsen of Wells Capital: another good year for the economy, and stocks, in store

Jim Paulsen of Wells Capital

I’ve written about Dr. Paulsen a couple of times before.  He’s an experienced and skilled commentator on the US economy and on financial markets.  I think he’s well worth reading.

My only worry is that his optimistic views often parallel mine.  On the one hand, it’s comforting to see that you’re not alone in your thinking.  On the other, any investor must fight the temptation to pay attention only to people who agree with you.

Wells Fargo also has a pro-active PR department.  I’ve been on Dr. Paulsen’s mailing list since the first time I mentioned him in PSI.

an important insight

His basic idea, one I agree with, is that the world has changed a lot since the 1970s and 1980s.  Therefore, comparing the current economic recovery to ones from way back then is wrong.  Nevertheless, that’s what most economists do–and conclude that this recovery is unusually slow.

If, however, we compare today with the situation after the recessions of 1990 and 2000, the recovery looks perfectly normal.  It’s slower than we’d like…but so too were the previous two.

Paulsen’s 2/12 newsletter

In his February 2012 Economic and Market Perspective, which wasn’t yet on the Wellscap website as I’m writing this, Dr. Paulsen goes into detail about the third year of a “modern” recovery, which he calls the “Gear Year.”  It isn’t necessarily about explosive earnings growth–that was the story earlier in 2010 ans 2011.  It’s all about restoration of confidence.

Consumers finally become convinced that we’re not going to slide back into recession.  So,

–bank lending increases rapidly

–housing beings to perk up

–consumer durables purchases, especially autos, accelerate.

That’s all happening now.

financial market implications


In Paulsen’s view, Wall Street was willing to pay 15x current earnings for stocks last year, until semi-crazy fears that recession would recur and/or that Europe would implode clipped 15% or so off that.  Earnings per share, at around $100 for the S&P 500, were unaffected.  The mid-year market swoon was all about (lack of) confidence and about resulting contraction in the multiple of earnings investors were willing to pay.

This year, the S&P 500 will earn something north of $100/share.  The cyclical return of confidence will cause the market’s PE multiple to expand as well.  This makes 1500, or about 10% higher than the current index level, a reasonable target.  Because the domestic economy will grow at 3%+ (a higher rate than the consensus expects),  cyclical sectors will lead the way.  Defensives will lag.

Stocks whose main attraction is the dividend are a particular worry, because…


Stronger than expected growth in the US and less damage emanating from the Eurozone together mean that the Fed will have to reconsider its zero interest rate policy much sooner than it has been planning.  This year, in fact.  In Paulsen’s view, the 10-year government bond yield may reach 3.5% by December.  That will dim the luster of dividend stocks.

my thoughts

I have some minor quibbles with Dr. Paulsen, but they don’t change the overall outlook.  He’s a tad more bullish than I am (hard to do for most people).  But the US is healing itself, and we may well be at a positive inflection point for investor confidence.

Two related points:

–3.5% is only a way station for the 10-year Treasury.  The Fed thinks a neutral Fed Funds rate is 4%+.  That would mean a 10-year yield above 5%.

–how will rising rates affect securities?  Bonds will suffer; the longer the maturity (or the longer the duration, a topic for another post), the worse the damage.

Stocks, on the other hand, have two defenses.  True, rising rates are a negative for the stock market.  But interest rates will start to rise because the economy is picking up and no longer needs low-rate life support.  That means profit growth will be accelerating.  Returning confidence may mean a higher multiple placed on these earnings, as well.

I wrote about this phenomenon about two years ago.  The post is a bit outdated and the “normal” interest rate figures I’d been estimating then are too low.  But the basic points are still valid, I think.  Most important, I have a chart showing S&P 500 behavior while interest rates are rising during economic recovery.  In the past, the market has always gone up while this is happening.

another sign of a toppy bond market in the US

running an ice cream stand

One of the most useful tips on company analysis I’ve ever gotten came from a former P&G marketing executive who was working for a hotel company when I heard him speak.

He said that if you run an ice cream stand that sells vanilla ice cream, you don’t start to sell strawberry (my favorite, by the way) until the market for vanilla stops growing.  In other words, once you see a company begin to segment the market for a product (by offering several varieties), you know that sales of the “plain vanilla” version are tapping out.

the new Pimco Total Return ETF

That’s my take on the Pimco announcement that it’s launching an ETF version of its total Return bond fund, the largest actively managed bond mutual fund on the planet, two days from now.  It means investors have stopped buying bond mutual funds from Pimco.  Since Pimco is the biggest bond manager and has the best long-term record, I think this also means investors have stopped buying bond mutual funds, period.

Remember, too, that Pimco–a unit of Deutsche Bank–is a marketing monster.  It’s executives are constantly pounding home their message, often packaged as “economic” commentary, that now is the best time to buy more bonds.  During the two decade+ period of secular long-term interest rate decline that ran from the early 1980s until recently, that stance was 100% correct.  Not anymore, though.

True, Pimco had a year to forget vs. peers in 2011.  But I don’t think that’s the issue.  Pimco’s long-term record is strong.  And the company had begun laying the groundwork for the new ETF before its performance weakness unfolded.  Despite Pimco’s relentless sales efforts, I think investors are finally catching on that bonds may not be the one-way street that they’ve come to expect.  Even if the light bulb hasn’t gone on, investors are at least signalling that they don’t think they need any more bonds.

ETFs aren’t a walk in the park

performance differences

Many bonds are surprisingly illiquid.  Pimco won’t be able to use the much more easy-to-trade derivatives market to change the shape of its ETF holdings in the way it does in its mutual fund portfolio, however.  So it’s possible that the ETF won’t track the mutual fund very closely.

That’s potentially a big concern.  Holders of the vehicle that’s doing less well will always be unhappy.

filling a need nobody has

So far, actively managed ETFs haven’t been very popular with investors, who have preferred low-cost passive products.


Cannibalization of the Total Return mutual fund by the lower-cost ETF might seem to be an issue, but I don’t think it is.  Two reasons:

–taxable investors with unrealized gains on their mutual fund holdings won’t switch to the ETF because they’d trigger capital gains tax

–it’s always better to cannibalize an existing product with a new one of your own rather than have a rival do it to you with one of his.


The new ETF will be interesting to watch, if nothing else to see how successful it is in gathering assets.   Still, I think it’s probably as close as we’ll get to a bell ringing to signal the top of the market.

exogenous events: how to deal with them

two preliminary points

stock market implications

Some exogenous threats/events have few.  For example:

–the Y2K worries that all the world’s computers would cease to function on January 1, 2000 turned out to be unfounded

–SARS was contained, and did not evolve into the worldwide pandemic some had feared

–I doubt French voters’ choice of a new president in upcoming elections will make a crucial difference in the way the Eurozone crisis will play out.

risk preferences

Let’s say that past market-moving exogenous events have depressed stock prices by 20% have taken six months to be fully discounted, just get a sense of possible loss.  I don’t think there is a “typical” exogenous event, however.  The two big oil shocks were a lot worse than that; after 9/1/2001, stock prices fell about 12% over a few days and then began to recover.

Still, the numbers allow me to frame a question.  If you thought a hard-to-analyze, but potentially negative, event might be coming down the road, would you change your allocation of assets to the stock market?  If you’re not okay with a (hopefully) temporary 20% loss in value, you should rethink where you have your money invested.

what makes an exogenous threat/event different?

1.  Exogenous events are typically all or nothing situations.  The event either happens or it doesn’t.  There are no shades of partly or maybe.  This makes it harder to hedge by arranging your stocks to benefit from a middle-of-the-road outcome.

2.  Their timing is very hard to judge.

3.  They typically occur in areas where understanding them requires knowledge outside the skills and experience of professional investors.  So they’re hard for investors to analyze and handicap.

4.  They can involve a relatively rapid (in macroeconomic terms, anyway) series of actions and counter-actions.  The exogenous threat of the moment–possible Israeli bombing of Iranian nuclear facilities–is an instance.  Will Israel bomb Iran?  If so, will Iran retaliate?…

my approach

When dealing with anything that’s important but hard to decide about, I think the ideal position for a portfolio to be in is one where the issue is irrelevant to performance.  In that way, you’re not forced to bet on something you have no insight into.  In the case of an exogenous event/threat, however, that may not be possible, particularly for a growth stock investor.

You can, and should, pay attention to two factors:  pre-event portfolio positioning, and having a reaction plan if/when the event occurs.

Let’s take the crisis du jour, an Israeli attack on Iran, as an example.

This is a highly emotionally charged and complex issue–one that I know little about.  The stock market fear is that Israel will bomb Iranian nuclear facilities, Iran will retaliate.  Oil prices will rise.  The world will be drawn into accelerating armed conflict in the Middle East.  Media reports suggest than any attack must commence before the end of 2012, by which time Iranian plants will supposedly be too heavily protected for an attack by Israel to be successful.

pre-event portfolio positioning

My guess is that an Israeli attack would produce a short, sharp drop in stock prices, similar to that after 9/11, followed by a period of assessment.

I don’t see any way of organizing a stock portfolio so that it wouldn’t be very sensitive to a selloff, other than to adopt a very defensive overall portfolio posture.  The problem with doing that is that it forfeits most upside from the time you put it in place.  Suppose the exogenous event doesn’t take place?  Or, suppose the market goes up by 10% before the event and then declines by 8% as it unfolds.  I thinks case, you’re probably still worse off from being defensive than you would have been by doing nothing.

What am I doing instead of this? …stuff I should be doing anyway, but I’m paying closer attention than usual.

–I’m combing through my portfolio for “iffy” stocks that have achieved most of the outperformance I’ve envisioned for them and which I’m holding onto partly from inertia, partly to maintain market exposure.  I’m starting to pare those positions back.

–I’m being more price conscious with anything I’m buying.

–I’m thinking about energy stocks, and US chemicals the use natural gas feedstocks–but I haven’t bought anything yet.

–I’d think twice about any companies I own that have plant and equipment in Israel (other than INTC, I have none that I’m aware of).

a reaction plan

This is at least as important as pre-event planning.  An awful lot depends on judging what’s going on while an event-related selloff is in progress.  But the general idea would be:

–to buy, rather than sell

–to search among the biggest losers for purchase candidates that have been beaten up without good reason

–to reverse the defensive moves you made in anticipation of the event.  In this case, this would mean selling energy producers and replacing them with energy users.

When to start such contrary moves depends as well.  When Saddam Hussein invaded Kuwait in early August 1990, for instance, oil stocks hit a peak of relative performance about two months after, in late September-early October.  That was long before the US attack on Saddam the following January sparked a general market upturn.

After 9/11, in contrast, the faster one bought the better.

“exogenous” events for securities markets: what they are


Exogenous means “coming from outside.”  In economic modelling, it means an influence that arises from outside the scope of model and that is, therefore, neither predicted nor explained by the model.

In financial markets, an exogenous event has come to mean:

–some really bad thing that occurs, which has a significant, enduring negative effect on prices, and

–one that’s outside the realm of everyday competition among firms, the cyclical rhythms of a nation’s business cycle or the interaction among countries.


The two “oil shocks” of the 1970s–both of which helped precipitate severe recessions in oil-importing countries–are the events most often cited as exogenous shocks.  Saddam Hussein’s invasion of Kuwait in 1990 is another, as is 9/11/2001.  So, too, is the near-collapse of the US financial system under the weight of dubious sub-prime mortgages.

A definitional point:  unless we’re talking about an invasion from space or a large meteor hitting the earth, no event can be exogenous for everybody.  When OPEC raised the price of oil from $1.70 a barrel to $30+, it was a bonanza for its members.  For the US and Europe, however, whose industry was deeply dependent on a steady flow of cheap petroleum products, the development was a disaster.

The sub-prime mortgage crisis was an exogenous event for the rest of the world, but an endogenous one for the US.

No one talks about the subsequent plunge of crude oil to below $10 a barrel as an exogenous event, either.  The term seems to be reserved for economic calamities that affect the large stock markets of the world.

exogenous events are predictable…

Anyone reading the founding documents of OPEC realizes that it’s a political organization, not an economic one.  It wanted justice, not monopoly profits.  And, although the full details weren’t apparent except after the fact, the production contracts between the oil majors and OPEC nations, which had sometimes been running for several decades, were extremely one-sided in the former’s favor.

…but they often come as a shock anyway…

Many times, professional investors’ focus is narrowly fixed on the domestic business cycle or the competitive interplay among firms in a given industry.  They don’t have any skill or interest in any other areas.  Experience also shows that “big picture” developments are often irrelevant for stocks.  The quality of the information generated by brokers–the biggest information channel professional investors use–about political/social topics is often very low.

…if nothing else, their timing is hard to gauge

OPEC was founded in 1960 but didn’t begin to make a significant impact on oil prices until 1970.  The roots of the sub-prime mortgage crisis can be traced back to Fed actions in 2002-2003, to G. W. Bush’s housing policy, or even to the Clinton administration.  Rampant housing speculation and sub-prime abuses were readily apparent in 2005-06.

In these cases, however, stock market consequences came much later.

being right can be a cold comfort for professionals

Any portfolio manager who adopted a very defensive posture in 2005 in anticipation of the Lehman collapse would doubtless have lost most of his clients before the event itself occurred in 2008.

In addition, one always has to calculate how the performance gained by being correct in predicting an exogenous event stacks up against the performance lost while waiting for the event to occur.  In my observation of “big picture” portfolio managers, their personal ego satisfaction is often the greatest gain they achieve.

In fact, I once had a PM who worked for me tell me that a stock bought eight years earlier, which had almost immediately dropped like a stone and was subsequently sold, hadn’t been a mistake after all.  How so?  The firm was in the process of being bought, by Warren Buffett, and at a higher price than the initial purchase.  Yes, that’s (more than) a little crazy.  But it shows how insidious cognitive dissonance can be.

That’s not to say we shouldn’t worry about exogenous events.  Quite the contrary, because they do occur.  And not all of them are complete bolts out of the blue.  But factoring them into portfolio strategy is a bit more complicated than it might seem.

the current worry

It’s Iran’s nuclear program.  More about this on Monday.




quantitative easing in Japan: implications

quantitative easing in Japan

With all eyes on Greece, one of the less noticed developments in global securities markets is the recent decline of the ¥ versus the US$.  As I’m writing this on Thursday morning, the ¥ has weakened from a high of ¥76 = US$1 reached on February 2nd to the current ¥80 = US$1.

This is not just the result of one of Japan’s periodic, ultimately fruitless, attempts to intervene in currency markets to temporarily weaken the ¥.  Instead, it’s the currency markets reaction to what appears to me to be a substantial shift toward monetary easing by the Bank of Japan.

Why do so?

After over two decades of minimal economic growth and mild deflation, citizens’ tolerance for political and bureaucratic bungling of Japan’s economic policy seems to me to have finally been exhausted.  Voters are deeply unhappy with the administration of the recently installed Democratic Party of Japan.  But no one wants the Liberal Democrats back either.  There’s serious discussion about forming a third political party–really radical thinking in a country where politics has been dominated by a single party, the LDP, for a half century.

There’s also been talk in the Diet of legislation that would take away from the Bank of Japan its Federal Reserve-like role in setting monetary policy.  This threat appears to be what’s prompted the central bank to launch the new program of quantitative easing.  The BoJ is basically saying that it will continue to inject money into the system in large amounts until inflation reappears.  In other words, the new stance is the Fed’s approach, but on steroids.


In the near term, this policy will likely continue to weaken the ¥, removing one source of pressure on the profits of Japanese export-oriented companies.  It’s already prompting investors in the Tokyo stock market to re-orient their portfolios toward export-oriented stocks.  I don’t think this policy move, by itself, has the slightest chance of removing Japan from the morass in which it has been trapped for many years, however.  And substantial negative consequences may lie down the road.

As anyone who has read me on Japan before knows, I think the fundamental issue for that economy is the ground-level social decision made twenty years ago not to adapt to a changing world, but to preserve the traditional social order even if that meant slower economic growth.  After all, the country did hide its banking problems for a decade.  Despite a shrinking workforce, it doesn’t allow immigration.  Its laws cement the management practices of twenty year ago–and most times the actual managers–in place and defends them from virtually all attempts at change. Iconoclasts risk social censure, or worse.

Sounds a lot like the Eurozone, doesn’t it–one currency, but keep the local power brokers in place?


Without substantial structural pro-growth reforms, what’s likely to happen?

For a while, nothing much.  The character of the stock market will continue to change, as investors shift away from smaller, counter-culture secular growth stocks to larger, older exporters.  But for foreign investors, a large part of any local currency gains will be erased by currency losses.  So it will be even harder to make money in Tokyo than before.

The strategy, however, seems to me to be playing with longer-term fire.  The central government has piled up a huge amount of debt, which it can continue to service both because interest rates are extremely low and because–lacking other investment alternatives–Japanese citizens continue to buy tons of government bonds.  Reemergence of inflation will mean, at the very least, rising nominal interest rates, and therefore rising debt service for the government.  In addition, in an all too rigid economy, inflation may spread relatively quickly and begin to have negative effects on the value of Japanese assets.  If so, Japanese investors may shift their money away from government bonds and toward inflation-protection vehicles, like real assets or foreign securities.  That might lead to further currency weakness and compound the government’s funding problem.  So a sovereign debt crisis, while not imminent, may be ultimately waiting in the wings.

what I’m doing in response

I own two Japanese stocks, DeNA and Gree.  I like them both, although each has taken its lumps as the market orients toward exporters.  I’m certainly not going to add new money to Japan.  And I’ve got to consider whether I lessen my exposure.  If DeNA and Gree didn’t have substantial businesses outside their domestic market, I’d be doing that already.