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.

 

 

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.