Although I don’t think I’ve ever met Jim Paulsen, I like his work. He’s fundamentally sound, with an optimistic bias–kind of the way I’d hope others would describe me.
As I read his most recent Economic and Market Perspective release, he’s trying awfully hard to be bullish …but can’t find enough facts that will support a bullish position.
The basic issue he’s dealing with is that, as he puts it, the S&P 500 entered 2015 trading at 18x trailing earnings, a high rating the index has achieved only about a quarter of the time in the past. On the surface, that’s not overly worrying. If we look at the wider universe of all US stocks, including smaller-cap issues, the NYSE Composite and Nasdaq, however, the US market is trading at record-high levels based on PE, price/cash flow and price/book.
Not only that, but the high valuations aren’t concentrated in a few market sectors, as was the case during the Internet Bubble of the late 1990s. The median stock has all the characteristics of the averages.
Paulsen’s thinks the best that we can hope for is that stocks will move sideways until value is restored through higher corporate earnings–a process that will probably take all of 2015. As I read him, he believes it’s highly unlikely that stocks can go up during this period. There’s a good chance of one or more declines of 10% during the year. Declines could be deeper. The only safe haven he can see is in stocks outside the US.
The one factor Paulsen may not be giving enough weight to is the price of alternative investments–here I mean bonds, not hedge funds.
Generally speaking, stocks and bonds are in equilibrium when the interest yield on bonds = the earnings yield on stocks, i.e. 1/PE.
In 1973, just before the onset of a major bear market, the 10-year treasury rate was 6.5%. This would imply a stock market multiple of 15. The actual multiple on the S&P was 19.
In 1987, just before another major market downturn, the 10-year yield was 7%, implying a stock market multiple of 14. The actual multiple was about 20.
In 1999, just before the Internet Bubble popped, the 10-year was yielding 6.7%, implying a stock market multiple of 15. The actual multiple was 30!
Right now, the 10-year Treasury is yielding 1.82%, implying a stock market multiple of 55! The actual multiple is 18.
My conclusion is that today we’re in a weird situation where there’s little relevant historical precedent.
If we work the bonds-stocks equivalence equation the other way and ask what 10-year Treasury yield an 18 multiple on the market implies, the answer is 5.5%. Even if we take Paulsen’s median multiple for all US stocks of 20, the 10-year Treasury yield should be 5.0%. This suggests the hard-to-fathom result that current stock prices already factor in all the tightening the Fed is likely to do over the next two or three years.
Looked at a little differently, significant stock market downturns come either when PEs are out of whack with bond yields or when earnings are about to evaporate because of recession, or both. Neither appears to be the case today. The closest I can come is the idea that the sharp depreciation of the euro will undermine the 2015 results of US companies with significant euro-based earnings or assets. But that exposure isn’t big enough to offset even tepid US domestic earnings growth. And I think the US will be much better than “tepid.”
the bottom line
The fact that an experienced dyed-in-the-wool bull has turned bearish is a cause for worry. It is also true that PEs are high. The key difference between Paulsen and myself is how we regard bonds as influencing stock pricing.