Jim Paulsen: lower lows, but not by much

Jim Paulsen, equity strategist for Wells Capital Management, an arm of Wells Fargo, gave an interview on CNBC yesterday.  It’s well worth listening to.

His main points:

–the stock market decline we’ve seen since November is all about adjustment to lower future earnings growth prospects.  This is being caused by the resumption of “normal” growth as the bounceback from deep recession is completed.  Another aspect of the return to normal is the economic drag from gradual end to extraordinary monetary stimulus, at least in the US.

In Mr. Paulsen’s view, the S&P 500 can trade at 16x trailing earnings in this new environment, not the 19x it was at two months ago.

–we may have seen the lows for the year last Wednesday at midday (1812 on the S&P 500).  More likely, the market will revisit those lows in the near future.  It will break below 1800 on the S&P, creating a fear-filled selling climax.

–assuming, as he does, that the S&P will end the year flat, i.e. around the 2044 where it closed 2015, a buyer at yesterday’s close would have a 9% return (11% dividends) from holding the index by yearend.  A buyer at 1800 would have a compelling 14% (16%) return.  11% might be enough to attract buyers; 16% surely will be.

–2017 will be a stronger year for earnings growth than 2015, implying that the market will rise further as/when it begins to discount next year’s earnings growth.

–the current selloff will trigger a market leadership change.  The new stars will likely be industrials, small-caps and foreign stocks.

Jim Paulsen’s latest on US stocks in 2015

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.

my take

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.

working backwards

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.

 

 

 

 

Jim Paulsen on 2015 (ii)

To recap:  yesterday I wrote about the latest investment newsletter from Jim Paulsen, a strategist at Wells Fargo.  In it he talks about a belief held widely (including, up until now, by me)–that the Fed’s program of raising interest rates from the current emergency-lows up to normal will be bad for bonds but have little impact on stocks.

How can stocks fare well as rates rise?

…because in past instances of post-recession rate increases, the negative effects of higher rates have turned out to be at least offset by the positive influence of stronger corporate earnings.  Hence, stocks go sideways to up.

Why is this time different?

Past tightening episodes have generally followed relatively mild recessions.  Tightening has come, say, a year after the bottom in economic activity, when the economic bounceback from the downturn is in full force.  Today, however, we’re more than five years past the recessionary low point.  Deferred demand has long since been satisfied.  So we can’t expect the same oomph from earnings comparisons that we’ve gotten in the past.  In fact, in Paulsen’s view, stocks are most likely to go down next year as Fed tightening begins.

Mr. Paulsen is smart, experienced–and has been right about stocks for at least the past five years.  So he’s someone whose opinion we have to take seriously.  He;s also a bull making a bearish statement.  For that reason alone, it’s worth consideration.

Another point in Paulsen’s favor:  the rest of the world seems not able to provide much support for S&P 500 earnings next year.  If anything, non-US businesses will be a drag on profit growth.

How might Paulsen be wrong?

I can think of three ways:

1.  It’s hard to predict the Fed’s tactics in raising rates.  The agency’s current plan is to start raising short-term rates sometime in the Spring and boost them by 0.25% every month or so, to arrive at around 1.50% by yearend.  However, if this timetable makes the stock market start to unravel, it’s conceivable–likely, in my view–the Fed will slow the pace, or even stop until stocks stabilize.  The disastrous moves by the Japanese government in the 1990s to prematurely return to normal–and the consequent lost quarter-century of economic growth–appear to be very fresh in the Fed’s mind.

2.  The Fed has been highly vocal for a long time about its plans.  They come as no surprise.  It’s possible, therefore, that investors have already made some adjustments in their thinking, and in their portfolios.  If so, the rate rise won’t be as harmful to financial markets as might be.

3.  (or maybe 2a, or both)  For investors not willing to hold highly illiquid investments in large amounts (that is, for almost all of us) the investment choice is among stocks, bonds and cash.  The return on cash will be negligible for a considerable time.  So the practical choice is between stocks and bonds.  Two points:

–the 30-year Treasury currently yields 3%.  An earnings yield on stocks of 3% translates (in the way Wall Street has generally worked since the 1980s) into a 33.3x price earnings multiple.  The S&P 500 is currently trading nowher close to that level, however.  It’s at less than 20x earnings.  20x earnings is the equivalent of a 5% yield on the 30-year Treasury.

I take this to mean the markets are already factoring into today’s stock prices a considerable rise in fixed income yields.  This doesn’t mean stocks won’t decline as rates start to rise.  But I think it does mean that part of this is already in prices and that the downside to stocks could be limited.

–we’re already beginning to see European bond managers buying US bonds.  They see: safe haven, higher current yields and rising currency (in euro terms) as offsets to possible losses from rising rates.  As rates begin to move higher, this trend may accelerate, bringing a higher dollar and a subdued effect on long-term bonds from rising short-term rates.  If long-term rates don’t rise less than expected, the effect on stocks should be positive.

what I’m doing

The rising currency scenario isn’t an unadulterated plus for the US.  Currency rises act in much the same way as interest rate increases do.  They lower economic activity.  Of particular concern to stock market investors, a dollar rise against the euro will lower the dollar-denominated results for S&P companies with European exposure.  That’s about a quarter of the S&P’s earnings total.

I don’t think we have to decide right away how stocks and bonds will play out next year.  But we do have to continue to assess possible outcomes and mull over what we want to do as new news makes one or another outcome seem more likely.