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).
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.