Jim Paulsen on the US stock market

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.

 

 

stock prices in a rising interest rate world (I)

Jim Paulsen

I’ve been a fan of Jim Paulsen of Wells Capital Management (part of Wells Fargo) for a while.  My only caution is that his thoughts and mine usually run along the same optimistic lines.  So he provides me more confirmation of my own views than a radically different viewpoint to test them against.

stocks should be okay

His latest Economic and Market Update, dated June 25th, talks about what happens to stocks when interest rates begin to rise after a recession.  He focuses on consumer confidence as the key variable to watch.  So far it’s signaling that stocks should be okay even as interest rates rise (and bond prices fall).

my thoughts

Up until now, I’ve been mostly satisfied with the argument that over the past thirty years stocks have always gone sideways to up as the Fed raises rates from recession-induced emergency lows.  Recently, though, I’ve been trying to think through what might go wrong this time.  All I can come up with is:

–the Baby Boom is older and has different investment preferences

–the road back to normal rates is an especially long one (in keeping with the severity of the Great Recession)

–market participants seem to me to be less thoughtful and more emotional (maybe the result of using cable tv as an information source).

None of these is enough to change my mind that stocks will be basically okay.  But I’ve also been looking for positive arguments that reach this conclusion–not just lack of strong reasons to be suspicious of past investor behavior in similar circumstances.

one key distinction to make…

…before we go any farther.

What we’re talking about is Fed action that brings money policy from accommodative (loose) to normal, not normal to restrictive (tight).  The difference?

–the Fed fights recession by setting short-term interest rates below the rate of inflation.  In other words, it more or less gives the money away to anyone who promises to spend it!!  It does this to simulate investment and consumption.  Ending the giveaway by moving rates back up to slightly above inflation and giving lenders a real return on their funds, is the move from loose to normal.

–on the other hand, when the economy is expanding too quickly and creating inflation, the Fed moves rates substantially higher than inflation.  Its intention is to slow economic activity back down to a sustainable rate.  That’s not what the Fed is doing now.  (In fact, it’s not even talking about stopping the giveaway.  It’s only suggesting it may slow down the rate at which it shovels the money out the door.

Paulsen’s observation

Paulsen’s main point in his June 25th strategy piece is that during periods when interest rates are rising, there’s a strong positive link between consumer confidence and stock market performance.  Historically, the S&P has advanced on average at a 12.8% annual rate during months when bond prices were falling but consumer confidence was rising.  However, when bonds were falling and confidence was dropping as well, the S&P also declined, at a 6.4% annual rate.

Paulsen cites two consumer confidence measures, the monthly Consumer Confidence Present Situation Index from the Conference Board, which has been advancing steadily since late 2011, and the daily Rasmumssen Consumer Confidence Index, which has also been rising since August 2012.  Both indices have continued to go up, despite the recent rise in Treasury bond yields.

In his strategy update, Paulsen is a little vague about what he thinks is in store for stocks.  He says, “Yes, yields are rising.  But the key is that improving confidence seems to be at the core of what is driving them higher.  If this continues, higher interest rates should not materially impact economic activity and the stock market may continue to provide favorable results.”

In a slightly earlier (June 18th) piece, Dr. Paulsen is more specific.  There, he says his guess is the S&P will move in a 1550 – 1750 range through yearend, before beginning to advance higher in 2014.

That’s providing consumer confidence continues to be strong.

More tomorrow.

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

stocks

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…

bonds

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.