Tag Archives: inflation

Jim Paulsen on the US stock market

September 11, 2015 By in Constructing a Portfolio, Current Market Thoughts, inflation vs deflation, Inventory Cycle, margins, Portfolio management, Recent Market Action, stock market, Strategy Tags: , , , , , , , , 3 Comments

Yesterday’s Financial Times contains a guest column by Jim Paulsen, strategist for Wells Capital, a part of Wells Fargo.  I find Mr. Paulsen’s work to be orignal, thoughtful and, for me, thought-provoking.  On the other hand–a warning–he and I share the same generally optimistic view on markets and have tended to agree on most basics.

Here’s what he has to say:

–the current market swoon may have been triggered by worries about the Chinese economy, but its real cause is to be found in the dynamics of the US economy/stock market

–US stocks were, and still are, trading at an unsustainably high price-earnings multiple.  The final bottom for stocks in this correction will be around 1800 on the S&P 500, or about 3% below the low of a few days ago.  That’s where stocks will be on a more reasonable 15x PE

–full employment in the US, i.e., where we are now, creates a series of problems for the economy and stock market.  Employers wishing to expand are forced to find new workers by bidding them away from other firms.  Since inflation in advanced economies is all about wage increases, poaching creates inflation.  In the short term at least, a higher wage bill means lower margins–and therefore lower profit growth.  The Fed responds to the inflation threat by raising interest rates, which exerts downward pressure on PEs

–investors don’t get this yet.  They’re “more calm and confident than at any other time in this recovery.”

–the combination of high PE, higher interest rates and slowing growth mean that equity investor focus will shift from the US to more fertile fields abroad.  These areas are more prospective because, unlike the US, they don’t face the need, caused by achieving full employment, to rein in the pace of domestic economic growth. I presume, although Mr. Paulson isn’t more specific, that this means the EU (it may also mean US stocks with high exposure to non-US economies).

my thoughts

Mr. Paulsen is in touch with institutional equity investors every day.  So he has a much better sense of the current thought processes of US professionals than I do.  He seems to feel his customers are only beginning to believe that the set of issues that come with full employment are at our doorstep–and are only now starting to discount them into stock prices.  Hence the correction.  While it’s risky to think you know more than the other guy–in this case, that the other guy slept through his elementary economics classes–I’m willing to go along and say it’s true.

Mr. Paulsen has previously made the point that interest rates are going to rise in an economy that doesn’t have much business cycle oomph left in it.  Therefore, he argues, past instances of cyclically rising rates, during which stocks generally were flat to up, may not be good guides to what will happen today.  I look at the situation in a different way.  If we ask where long Treasuries will be at the end of Fed tightening, the answer is that they’ll likely be yielding less than 4%.  If we think that the yield on Treasuries and the earnings yield (1/PE) on stocks should be roughly equivalent, then the implied PE on the S&P is 25x.

One might argue that the idea of the equivalence of earnings yield and interest yield arises from a long period in which Baby Boomers preferred stocks to bonds.  As Boomers have aged, that preference has reversed itself, meaning that yield equivalence between stocks and bonds may be too rosy a view for stocks.  If we assume that stocks trade at a 20% discount to this yield parity, however, the implied PE at the end of rate hikes is still 20.

Both results are a long way from the 15x that Mr. Paulsen proposes for the S&P.

It’s often the case that a significant drop in stocks often signals a leadership change.  I think it makes a lot of sense to reverse portfolio polarity away from an emphasis on earnings coming from the US to profits generated abroad.  How exactly to carry this idea out is the key, though.

 

 

navigating the next twelve months (i)

June 8, 2015 By in Current Market Thoughts, Portfolio management, Recent Market Action, Strategy Tags: , , , , , , , , , 3 Comments

As I wrote on Friday, I think we’re at an inflection point in the US stock market.  It seems to me the market is now beginning to take seriously the idea that the Fed will soon be beginning to raise interest rates from the current near-zero.

In one sense, this is not Wall Street’s first rodeo.  There are plenty of times in the past when the Fed has been reversing emergency monetary accommodation applied during a recession.  The investment community has already sifted through them ad nauseam.

On the other hand, the extent and duration of the current monetary easing are both without precedent.  At the same time, the way the market factors new information into stock prices has changed considerably over the last decade.  The goals and risk preferences of the Baby Boom, the most powerful retail influence on stocks, have shifted as well, as that generation has aged.

Boomers are more interested in income than in capital gains.  Hedge fund managers and algorithm-fashioners seem to have very short time horizons–almost reacting to information as it hits the news media rather than anticipating it.  (I almost cringe to write this last.  It reads a lot like the criticisms made by elderly patrician money managers of the past (whom I made fun of at the time) who held stocks for decades at a time and were struggling to adjust to the faster-paced market of my early years on Wall Street.  Still, I think what I’m saying is correct.)

Therefore, I think, we can’t just blindly apply generalizations from the past to our present situations.

two types of tightening

It’s important from the outset to distinguish between two types of Fed tightening:

–restoration of the real rate of interest from negative to positive as the economy recovers from recession, and

–raising the real rate of interest substantially above inflation in order to slow down an economy that’s potentially overheating.

Today, we’re dealing with the first kind, not the second.

what the past tells us

During past periods of Fed tightening of the first type, stocks have been volatile but have generally gone sideways to up.  Bonds, on the other hand, go down.

This, in itself, has implications for stock market strategy.  Stocks that resemble bonds the most tend to do particularly badly; (at least some of) those that resemble bonds the least do the best.

More tomorrow.

 

 

worrying about productivity

May 8, 2015 By in economics, employment, wage gains Tags: , , , , , , , Leave a comment

getting GDP growth

Looking at GDP from a labor perspective, growth comes either from having more workers or from more productivity, that is, from workers creating more stuff per hour on the job.  (Yes, you can get more output by not letting workers go home and forcing them to work 100 hours a week.  But that’s not going to last long, so economists generally ignore this possibility.)

The trend growth rate of the population in the US is, depending on who we ask, somewhere between +.7% and +1.0% per year. For reasons best known to itself,  Congress spends an inordinately large amount of time, in my view, devising ways to keep a lid on this paltry number by prohibiting immigration.  So, as a practical matter, the only way to get GDP to expand in the US by more than 1% is through productivity growth.

 

The weird thing about productivity is that it’s a residual.  We don’t see it directly.  Productivity is a catchall term for the “extra” GDP that a country delivers above what can be explained by growth in the number of people employed.  Economists figure it’s the result of employers providing better machinery for workers to use, technological change, and improved education + on the job training.

Productivity peaked in the US shortly after the turn of the century at around +2% per year, accounting for the lion’s share of national GDP growth.  It has been falling steadily since.  Over the December 2014 and March 2015 quarters, productivity dipped into negative territory.  This is hopefully a statistical quirk and not the sudden onset of mass senior moments throughout the workplace.

why worry?

Over the long term, the disappearance of growth through productivity gains implies economic stagnation in the US.  (My personal view is that the productivity number are the aggregation of a highly productive tech-oriented sector and a low/no-productivity rest of us hobbled by a weak public education system   …but, as a practical matter, who knows?   By the way, productivity figures don’t include government.)

The more pressing issue is that no productivity gains means employers aren’t finding ways to make their employees create more output per hour worked.  That is, they have no way of offsetting  higher wages other than to try to pass costs on by raising prices.

the bottom line for investors

Conventional wisdom is that the Fed will take a long time to shift from extreme economic stimulation through emergency-low interest rates back to normality.  Both stock and bond prices also seem to me to have imbedded in them the idea that “normal” will be lower in nominal terms than it has been in the past.

A bout of inflation induced by rising wages could change that thinking in a heartbeat.

To be clear, dangerously accelerating inflation isn’t my base case for how the economy will play out.  And no one is thinking that the US will only grow at about 1% annually from now on.  All the more reason to keep a close eye on how productivity figures evolve.

inflation on the rise?

May 5, 2015 By in bond market, currency effects, currency markets, Current Market Thoughts, Dividends, inflation, securities markets, stock market, Strategy Tags: , , , , , , , Leave a comment

Regular readers know that I like the economic work done by Jim Paulsen of Wells Capital, the Wells Fargo investment management arm.  His May 1st “Economic and Market Perspective” piece argues that the US has turned the corner on inflation, which will –contrary to consensus beliefs–be on the rise from now on.

His argument:

–the first signs of upward wage pressure in the US are now becoming visible (in developed economies, inflation is all about wages)

–recently, a rising dollar has kept the price of imported goods from rising (in some cases, they’ve been falling) and suppressed demand for US goods abroad.  That’s changing, turning the currency from a deflationary force into in inflationary one

–productivity is low, meaning that companies will have no way of offsetting higher wages other than to raise prices

–in past economic cycles, the Fed has somehow invariably remained too loose for too long.

 

I’m not 100% convinced that Paulsen is correct, and to be clear, he expects only mild inflation, but I’ll add another point to the list:

–although it doesn’t talk much about this any more, the Fed has clearly in mind the lost quarter-century in Japan, where on three separate occasions the government cut off a budding recovery by being too tight too soon.  In other words, there’s little to gain–and a lot to lose–by being aggressive on the money tightening trigger.

 

Suppose Jim is right.  What are the implications for stocks?  This is something we should at least be tossing around in our heads , so we can have a plan in mind for how to adjust our portfolios for a more inflationary environment.

My thoughts:

–inflation is really bad for bonds.  As an asset class, stocks benefit by default.  But bond-like stocks–that is, those with little growth and whose main attraction is their dividend yield–will be hurt by this resemblance.

–if the dollar is at or past its peak, it’s time to look for domestic-oriented stocks in the EU and euro earners in the US (the basic rule here is that we want to have revenues in the strong currency and costs in the weak).

–companies that can raise their prices, firms whose labor costs are a small percentage of the total, and consumer-oriented firms that are able to expand unit volumes without much capital investment should all do well.

–I think that average workers, not the affluent, are the main beneficiaries of a general rise in wages.  So firms that cater to them may be the best performers.

 

 

 

inflationary and deflationary mindsets

January 12, 2015 By in bond market, inflation vs deflation Tags: , , , 1 Comment

It’s fascinating to see how glibly and assuredly financial commentators and their guests have been talking about both inflation/deflation since the onset of the Great Recession.  What I keep thinking when I hear them is that to have practical experience of either phenomenon someone must either have lived in Japan or an emerging economy, or been an adult during the 1970s.  So most of these “experts” are just rehashing what they learned in a textbook.

What I think is important to consider about either inflation or deflation:

–what makes either dangerous is not simply that occasional spells of price rise/fall can happen.  It’s the possibility that people will begin to believe that inflation/deflation has become a permanent fact of life and alter their economic behavior to take this into account.  A mindset change, in other words.  Once that happens–and inflation/deflation is entrenched–it becomes extremely difficult to eradicate.  (In the inflation case, companies/consumers tend to favor hard assets over bonds or bank accounts, to consumer heavily and to avoid saving.  In deflation, they tend to hoard, underconsume and–again–favor hard assets like gold.)

–inflation and deflation are not mirror images of one another.  Historically, inflation has tended to spiral upward at ever-increasing velocity but can be cured by the monetary authority in a country boosting interest rates high into positive real territory.  Deflation, on the other hand, has tended to be a continuous downward grind.  Positive interest rates make borrowing a crushing burden.  The cure requires slower-to-act, less-likely-to-be-done fiscal stimulation or structural economic reform.

–in advanced economies, inflation and deflation are all about changes in wages.

–Japan is the current deflation poster child.  Its economic experience over the past quarter-century is the main reason, I think, that the word “deflation” strikes so much fear into global investors’ hearts.  Japan has recently devalued its currency by almost half in a so far vain attempt to get wages to rise.  In fact, real incomes for ordinary citizens have declined, because the local currency price of imported commodities like food and fuel has risen while wages have been relatively flat.

Japan is unusual in two ways, however:

—-the population is significantly older than in the EU or the US.  The local workforce has been declining for many years because of retirements; the country is strongly opposed to immigration.

—-resistance to structural change of any sort, and particularly change led by foreigners, is extremely strong.  As far as I can see, Japanese industrial technology is stuck back in the 1980s, maybe for this cultural reason.

It’s possible, therefore, that Japan’s current woes are more a function of an aging, hidebound population than anything else.  If so, then generic treatment of deflation–monetary and fiscal expansion–isn’t going to have much of an effect.  Unfortunately for the EU, “aging, hidebound” also sounds an awful lot like Europe.  So the EU may be next in line for the lost-decade syndrome.

Two other caveats:

–historical instances of inflation and deflation in the US have come during times when fixed-interest-rate bank lending was the norm for raising debt finance.  A changing price level could alter the real cost of that debt significantly.  This is no longer the case.

–indexing of wages and prices was common in the US during the 1970s and could easily have acted as a transmission mechanism for inflation.  Again, this is no longer the case.

my bottom line

I think the current economic situation is a lot more complex than pundits are making it out to be.  I also think they’re making a fundamental mistake by failing to distinguish between transitory inflationary/deflationary influences, like commodity price changes, and more fundamental, mindset-changing ones.  My guess is that this is because they’ve only read about the phenomena in books.