Wells Capital Management's Chief Investment Strategist, Jim Paulsen, has just released his exhaustive investment outlook. The complete report, which is longer than the following prefacing text, follows in a slidedeck, which you can either download or fullscreen.
by James Paulsen, Chief Investment Strategist
Wells Capital Management
Since its collapse in early August, the stock market has experienced extreme daily price volatility oscillating within a broad range. These emotional daily price swings reflect a skittish investor struggling with a dichotomy between extremely attractive relative stock market valuations and an array of escalating fears. Investor worries include a widening contagion from the European sovereign debt crisis, the potential for a hard landing among emerging world economies, uncertainty introduced by uncommon and confusing Federal Reserve policy actions, and the likelihood of yet another debt ceiling debate looming on the horizon.
While these concerns should keep daily price volatility elevated, how the stock market ultimately breaks from its recent trading range will probably be determined by whether the U.S. economy avoids recession. In the next several weeks, economic reports will either galvanize recession expectations or consensus fears will once again calm, embracing the likelyhood that the U.S. economic recovery will persevere. Should a recession become obvious, the stock market would likely suffer a further significant decline. Alternatively, investor greed may dominate the rest of this year should recession fears fade as investors act to take advantage of a valuation metric (about 11 times earnings with a sub-2 percent 10-year Treasury) which, without a recession, represents a fire sale!
A U.S. Recession?
An imminent U.S. recession is unlikely. First, the traditional economic policies which precede a recession are not evident. The U.S. does not possess an inverted yield curve, has not been subjected to significant short-term nor long-term interest rate hikes, and is not suffering from restrictive liquidity conditions or tight fiscal policies.
Second, can the U.S. suffer a recession when there is nothing to recess? Recessions often result from “excesses in need of a correction.” Since the last recession ended only two years ago and since it was so extreme, private sector players have thus far been well-behaved in the contemporary recovery. Are individuals paying up too much for houses today? Have consumers extinguished pent-up demands for durable goods? Is the savings rate too low (the savings rate has been hovering about a 20-year high since the recovery began)? Are household debt burdens oppressive (the household debt service burden is in its lowest quartile since 1980 and no higher today than it was in 1985)? Have banks been aggressively overextending loans? Has anyone been borrowing too much lately? Are companies overstaffed? Overinventoried? Have businesses over invested in the last couple years? Has the Fed tightened too aggressively? Have bond vigilantes raised bond yields too much? Too much fiscal tightening lately? Is anyone lacking for liquidity? Are households overexposed to the stock market today? Is optimism over the top? It is hard to see why the U.S. would experience a recession when almost nothing requires a “correction.” Indeed, before the next U.S. recession, the answer to at least some of these questions will likely be yes!
Third, despite a significant economic slowdown since early this year (annualized real GDP growth rose only 0.7 percent in the first half and real GDI growth rose by only 2 percent), the economy is already showing some signs of bouncing. After flattening earlier this year, real personal consumption is on pace to rise more than 1.5 percent in the third quarter, weekly retail chain store sales have remained relatively robust, and the annualized U.S. auto sales rate has risen by more than 14 percent since June to 13.1 million, helped by Japan bouncing back from its tsunami. Weekly unemployment insurance claims remain in the low 400,000 range, reported private sector ADP employment gains have averaged 100,000 in the last two months and layoff announcements as recorded by the Challenger Job Cuts Index have remained subdued.
Corporate profits are still robust, industrial production posted back-to-back gains in July and August, and recent reports for factory orders and durable goods shipments suggest business spending may have accelerated. The ISM manufacturing survey surprisingly increased in September to 51.6 and the ISM services survey is at a solid 53.3. Finally, U.S. net exports improved significantly in July suggesting international trade will add to third quarter growth. Overall, we expect real GDP growth to be between 2 to 2.5 percent in the third quarter— hardly a recessionary reading.
Fourth, new “policy stimulus” added in recent months should soon improve the pace of economic growth. Many worry the Fed is out of bullets and fear fiscal authorities have been neutralized by gridlock leaving the economic recovery without policy assistance. Although the abilities of policy officials may be limited, the economy has turned to “self-medication.” The national average 30-year mortgage rate has fallen from 5.2 percent in February to only about 4 percent today! Similar yield declines since the spring have been recorded by investment grade corporate bonds and by municipal securities. This “large” decline in long-term credit costs should help boost economic performance in the next several months. Both consumers and businesses should also get a boost from lower energy cost. Crude oil and gasoline prices have declined by more than 20 percent from peak levels earlier this year. Furthermore, even though the U.S. dollar has recently risen, the real broad U.S. Dollar Index is still about 10 percent lower today than it was in 2010 suggesting additional improvement is forthcoming in U.S. trade flows. The U.S. M2 money supply has exploded since June growing at an annualized pace of about 25 percent! Finally, as Japan bounces back from its economic collapse after the early-year earthquake, U.S. manufacturing supply chain problems should alleviate further in the next several months. Indeed, U.S. auto sales have already strengthened significantly in recent months as the Japanese impact diminishes.
What About Europe?
Unlike the U.S., the Euro region has been subjected to significant monetary and fiscal tightening in the last year and does exhibit characteristics of a pre-recessionary economy. However, how serious is the risk of either a recessionary or sluggishly growing Euro region for investors?
The best news surrounding the Euro crisis is it has finally gotten so bad! When the Euro sovereign debt crisis first broke in January 2010, the major players (EMU policy officials, Germany and France) perceived the problem as a political issue. Consequently, the crisis has not received any substantial assistance aimed at ending the economic and financial contagion. Only recently have the major powers in the region decided it is an economic threat and have begun to treat it more appropriately. Since officials have done so little yet to arrest the crisis, many weapons are still left in the tool box. Only recently, EMU officials finally suggested they will stop raising interest rates. Soon they will begin to lower interest rates, perhaps pursue some non-sterilized bond purchases (i.e., those that actually expand the central banks balance sheet and thus represent a true easing of monetary conditions), and even entertain a European-style TARP program similar to the U.S. approach used in 2008 to backstop ailing banks. After almost two years of smoldering into a major economic threat, there is understandably great concern the crisis cannot be controlled nor extinguished. However, the lack of success to date is primarily because so little has been done to address the crisis. This is beginning to change and will likely lead to much better results in the coming year.
The most serious threat for the U.S. economy is not a period of sluggish or nonexistent Euro region growth but rather a full-blown global financial contagion. Although possible, this seems highly unlikely in our view. First, the problems are well-known and have been for some time. A more serious financial contagion could hardly be a “surprise” which is often the most difficult aspect of crises. Second, most U.S. financial institutions do not hold large amounts of troubled sovereign securities. Third, even if a financial contagion were to infiltrate the U.S. financial system, because of responses to the 2008 U.S. crisis, the U.S. system is now very well capitalized, it has already experienced a major write down of bad debts, and is more highly liquid than in decades. Perhaps this is why for the first time, European and U.S. 10-year government swap spreads have significantly delinked. Euro swap spreads have exploded to 2008 wides while U.S. spreads remain near their lowest levels of the last decade.
The more likely U.S. fallout from the Euro crisis is a sluggish Euro region economic performance which would reduce U.S. export markets. While this is very likely, it may have much smaller impact then most fear. Outside of the Euro region, economic growth is likely to be maintained including Japan, Canada, Australia, the emerging world economies, and in the U.S. It is worth remembering that in 1990 the world’s largest economy at the time, Japan, fell into a depression from which it would not return. Nonetheless, the rest of the world including the U.S. proceeded to enjoy an economic boom during the balance of the 1990s! Today, the world economy is comprised by a new economic force (emerging world economies), which did not exist in any meaningful fashion in 1990, which should help diminish the impact of a smaller growth contribution from Europe.
How About China and the Emerging World?
A much more serious blow to the global economic recovery would be a recession in the emerging world. Despite widespread fears of such an event, we think a “soft landing” is a better description of what is happening among emerging world economies. During much of 2010, investors worried about China and other emerging economies overheating and collapsing. As a result, most emerging economy policy officials have been tightening conditions in the last year leading to a noticeably slower growing emerging world. However, now policy officials in this region are beginning to turn back toward easing policies after most economies have slowed. For example, Chinese real GDP growth has slowed to a still very robust 9 percent rate from about 12 percent last year. This is probably a healthy development and makes it more likely the global economic recovery will prove longer-lasting. Recently, China reported the second consecutive monthly rise in its manufacturing ISM survey to 51.2 in September! The easing policies now being increasingly employed throughout the emerging world suggests a quicker economic growth from this part of the globe in the coming year.
Market Signals are Flashing Caution???
U.S. recession expectations have risen primarily because several financial market indicators are providing signals which often precede a recession. That is, recession fears are due less to worsening economic fundamentals than they are being driven by worsening financial market signals.
The good news is the old adage which goes something like “the stock market has predicted 12 of the last five recessions.” While financial markets always worsen prior to recessions, poor financial market action also frequently precedes temporary economic slowdowns or panics. Consequently, it is hard to interpret the message of the markets. However, given the extraordinarily fearful, crisis-phobic culture which has dominated since 2008, a good deal of caution should be employed when relying on survey reports and market signals (markets which have been amazingly emotional driven) to access where the economy is headed. We are certainly in the middle of an intense panic. A panic which may last longer and take financial markets even lower before it is extinguished. However, fundamentally the U.S. economy remains sound, has some momentum, and because of self-applied stimulus since spring, is likely to improve in the months ahead. Moreover, Euroland problems finally seem to be receiving the “economic/ policy” attention it deserved a lot sooner. Finally, the rest of the global economy, like the U.S., is still growing (more likely in a temporary slowdown) or even growing quite rapidly (e.g., emerging world). Contemporary financial market signals, owing to the current remarkably emotionally-volatile period, may be exaggerating upcoming economic problems and underestimating the potential for an economic reacceleration.
Outlook for the Stock Market?!?
The fate of the U.S. stock market during the balance of this year will not likely be determined by Euro crisis fears, by Fed actions, by a jobs bill, or by debt ceiling debates. Rather, the stock market is likely to be driven by whether or not the U.S. avoids a recession. That is, the stock market will ultimately rally or fail based on economic data flow coming from Main Street USA.
Should the data convincingly portray a U.S. recession, the stock market will likely decline significantly further from current levels. With the S&P 500 Index currently slightly below 1100, the stock market already seems to be discounting a recessionary decline in earnings to about $70 (from the current likely yearend level without a recession of about $100). That is, based on this recessionary earnings expectation, the stock market currently sells at about 15 to 16 times which is a reasonable recession valuation given a sub-2 percent 10-year Treasury bond yield. Moreover, we believe if a recession does actually occur, “panic” will likely cause a much deeper decline in earnings producing further downside risk in the stock market.
Fortunately, we believe the chance of a U.S. recession remains quite low. If, during the next few weeks, the upcoming jobs report shows positive gains (even if sluggish) and if unemployment claims, retails chain store sales, and other timely economic data do not fall off a cliff suggestive of a recession, investor greed will likely return and begin to dominate the financial markets. If a consensus comes to believe a U.S. recession is “off the table,” the current valuation metric of less than 11 times year-end earnings while the 10-year Treasury yield is at a record low will become far too enticing.
We think a consensus which agreed the economic recovery will persist would result in a stock market willing to pay perhaps around 14 times for 2012 earnings of between $105 and $110 or a target price of about 1500! This is not necessarily our forecast for next year, but rather an illustration of the investment potential which exists should consensus recession fears fade.
The incredible daily volatility exhibited by stock prices during the last two months is frightening and tiring. It seemingly makes no sense when valuations can change so radically, so quickly, with little or no new fundamental information. However, the character of these types of markets, these periodic “gut checks,” may be what is in store for investors during this highly crisisphobic period in financial history. Our best guess is investors should try to stay focused on fundamentals and not on the “market’s daily assessment of its worst crisis fears.” Ultimately, we believe the U.S. and global economy is in a recovery—a recovery which will prove bumpy but will also likely prove persistent. And, if it does, those investors which approach this decline in the stock market as an opportunity to raise exposure to cyclical sectors will likely fare best in the coming years.
James W. Paulsen, Ph.D.
Chief Investment Strategist, Wells Capital Management
