September 2009 Economic & Market Perspective - Wells Capital Management

1. September 2009
Economic and Market
2009-Issue 5 “Bringing you national and global economic trends for over 25 years”
In This Issue: Despite a continuous advance in the stock market, a steady stream of better-than-expected
economic reports around the globe, back-to-back quarters of outperforming earnings reports,
and rising earnings estimate revisions for the third quarter, doubts surrounding the strength and
Monetary Worry!!? durability of any economic or stock market recovery remain widespread. A recent national AP
poll suggests 80 percent of Americans currently believe the economy remains poor and 60 percent
believe the economic policies put in place by the U.S. government will not work! However,
Six Forces For Growth!?! positive fundamental forces have improved economic conditions around the globe and, despite
ongoing pessimism, these forces should continue to promote further recovery in the coming year.
Consumer May Not Be Six Forces For Economic Growth!!!?
Several factors are combining to produce an economic recovery. First is massive and
DOA??! unprecedented economic policy stimulus! Since the Lehman collapse one year ago, the annual
growth in the M2 money supply has surged to between 8 and 10 percent. Trailing 12-month
Federal deficit spending has exploded from about $350 billion to almost $1.4 trillion! Short-term
It’s A Low, Low, Low Rate interest rates were lowered to essentially zero, and long-term bond yields hover at some of the
World!!? lowest levels in U.S. history! Moreover, the yield curve remains at one of its steepest positions in
the postwar era! Finally, oil prices are down by more than one-half from their peaks last summer!
May “Buy-And-Hold” Second is the reversal of the U.S. corporate purge! In the last year, businesses have been preparing
to survive a second coming of the Great Depression by purging inventories, payrolls, and capital
RIP!!?? spending plans. Now, as it becomes clear a depression will not result, and indeed an economic
recovery is forming, most businesses find themselves understaffed without any goods on the shelf!
Overall, economic growth should be enhanced as business is forced to “reverse the purge”!
Gold Prices Overvalued??!
Third is a slow steady rise in economic confidence. The Conference Board’s Consumer
Confidence Index has risen from its all-time low of 25.3 in February to 54.1 in August. However,
Will Velocity Turn??!? despite this significant recovery, the confidence index is only back to a level that approximates
the recessionary lows of the 1975, 1980, 1982, 1990, and 2001 recessions! Therefore, rising
confidence should remain a central force in driving economic growth for the foreseeable future!
An Earnings-Driven,
À La 1960s-Style Bull Fourth, after constantly subtracting from economic growth, housing and autos will likely “add” to
third-quarter real GDP growth for the first time since early 2006! Simply by no longer representing
Market!!!? a “negative” force, even if housing and autos only flatten in the next year, they will be additive to
overall economic growth.
Fifth, domestic net exports are now boosting U.S. real GDP growth! Indeed, international trade may
well prove a dominant force for U.S. growth in the next several years! Global export trends have
recently started to rise again after suffering a major recessionary collapse last year. The U.S. trade
deficit with the emerging world has finally been improving for the first time in at least a decade.
Finally, two major negative forces for the recovery—rising mortgage rates and surging energy
prices—have stalled in the last few months, even though economic reports have continued to improve.
The longer these two negatives remain range-bound, the more time this recovery has to mature, gain
strength, and achieve solid footing.
Massive policy stimulus, a corporate purge reversal, improving economy-wide confidence, a
bottoming in housing and autos, an improving contribution from net exports, and a stall in the rise
of mortgage rates and oil prices should foster a recovery that continues to surpass expectations. Our
best guess is for real GDP growth to average around 4 percent in the next 18 months, without a high
probability on double-dip concerns.

2. Economic & Market Perspective
Too Early To Evaluate The U.S. Consumer!??! For those who believe the emerging world is not yet developed
Many expect a sluggish recovery because they believe the U.S. enough to represent a meaningful global consumer force, look
consumer will be forced to deleverage. Some already point to no further than the “emerging world headliners”! Imports from
current sluggishness in consumer spending and debt growth as emerging world “headliners” (i.e., from China, India, and
evidence that household behaviors have changed. We think it is Mexico) as a percent of total world imports has risen from only
too early to evaluate whether the U.S. consumer will respond about 5 percent one decade ago to about 11 percent today. For
to policy stimulus and boost spending or whether spending is comparison, U.S. imports comprised more than 15 percent of
likely to stay subdued despite stimulus as households embark on world imports in 1998 (or about three times the imports from the
balance sheet restoration. emerging world headliners) but comprise only 12.4 percent today
(only about 1 percent more than the “headliners”)! This may be
Why shouldn’t current consumer confidence be low and the first global recovery where emerging world imports constitute
spending trends weak when job losses are still pronounced a very meaningful proportion of global trade.
and private income trends are still contracting? We do not
expect healthy consumer spending “until” job creation returns. Inflation, Deflation, Or ……. Neither????
Probably a couple of quarters of positive real GDP growth and Inflation typically declines for 18 to 24 months “after” a
at least a few months of job gains are required before judgment recession ends. Unemployment (both labor and factory capacity)
can be passed on the postrecession state of the U.S. consumer. created during the recession produces downward pressure on
both core consumer prices and wages even though real GDP
In the meantime, we are encouraged by a few indicators. growth again turns positive.
During this recession, consumer spending has actually remained
stronger than expected considering the collapse in job creation. Currently, there are both inflation and deflation alarmists. Some
Typically, real consumption growth has been about 2 to 3 believe the massive policy response to this crisis will eventually
percent faster than job growth. In the last year, however, even prove inflationary; however, others believe this crisis has not yet
though jobs have declined by about 4.5 percent, real consumer ended and expect a “stage two,” which will produce destructive
spending is down less than 1 percent! We also are encouraged deflation. Our own view is the economy is most likely headed
by the response of household spending to “deals”! The Cash for a period of “price stability,” which may calm fears on both
for Clunkers program and housing sales promoted by rapidly ends of the spectrum. Inflationists may gain fuel as real GDP
falling foreclosure pricing insinuate that widespread rumors of growth turns positive but will probably be kept in check by
the consumer’s death may again be greatly exaggerated! We monthly core consumer price inflation and wage reports that
suspect, after a couple of quarters of renewed real GDP growth, remain moderate. Even though core consumer price and wage
most will be surprised by a revival in the old “spendy culture” inflation will likely decelerate throughout 2010, deflationists may
of the U.S. consumer. have a hard time gaining traction if real GDP growth averages
(as we expect) around 4 percent. A traditional post recession
Best News For Jobs? ....... Profits!!! deceleration in inflation could force the 2010 annual core
The pace of job creation will ultimately determine consumer consumer price inflation rate to between 0 and 1 percent and the
spending growth. And, the most important force behind job annual wage inflation rate to between 1 and 2 percent. If real
creation is profits, where the news has been encouraging! GDP growth is as strong as we think is likely, when combined
Total U.S. corporate profits have risen in each of the first two with a decelerating core inflation picture, it may leave a bullish
quarters this year by almost a 23 percent annualized pace! More impression of “growth with price stability”!
important, profit per job has risen at almost a 30 percent annual
rate! Since at least 1960, whenever profit per job has risen by Longer-term, inflation risk has certainly been elevated by the
this much from recession lows, nonfarm payroll employment massive accommodative policies introduced during this crisis.
was either at or near a bottom. However, ultimate inflation risk will depend on many factors
(e.g., how fast policies are reversed, bond vigilante reactions,
Emerging World Consumer IS A Force For speed of recovery, strength of U.S. consumer spending, growth
GROWTH!!!? rate of emerging world, U.S. dollar weakness, recovery in
Even if U.S. consumption does prove subdued in the coming borrowing propensities, etc). We are not convinced the U.S. is
recovery, it may be at least partially offset by a nontraditional or is not headed for a longer-term inflationary episode and will
outsized contribution from newfound emerging world monitor how these factors evolve. In the meantime, solid real
consumers. By our estimates, total private emerging world growth with stable core prices seems most likely during the next
consumption in U.S. dollars has risen from about 60 percent couple years.
of U.S. consumption in 2003 to almost 92 percent of U.S.
consumption in 2008! Moreover, in recent years, emerging Gold & TIPS???!
world consumption has grown more than twice as fast as U.S. Because we expect core inflation to remain relatively tame
consumption and has outpaced U.S. spending in each of the in the next couple years, we would caution investors against
last 6 years! Finally, compared to U.S. households, this new becoming too overexposed to inflation-protected investments.
consumer force is much younger and possesses burgeoning first- Diversification demands some exposure to inflation hedges, but
time desires, low debt, and high savings! we recommend underweighting at least two major inflationary
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3. September 2009
plays—gold and TIPS. Currently, these investments are crisis, businesses became extremely lean and mean, and most now
simply too popular, reflecting widespread concerns about possess considerable profit leverage. This was already evident
inflationary possibilities. during the first two quarters of this year when earnings outpaced
expectations primarily due to margin enhancements. Soon, as the
Ten-year Treasury TIPS are currently priced at a 1.8 percent recovery matures, companies will begin to mix improved top-line
consumer price inflation rate, while the actual current core inflation results with enhanced operating leverage to produce a pronounced,
rate is only 1.5 percent and decelerating. TIPS are not necessarily and perhaps prolonged, profit cycle!
overvalued, but they are not extremely cheap and may prove
disappointing if core inflation does decline as we think is likely. An earnings-driven bull market is not something most contemporary
investors have experienced! Since interest rates and inflation peaked
Gold prices do appear “overvalued”! Between 1980 and 2008, the in 1980, bull markets have been driven by chronically declining
price of gold as a ratio of the overall CRB commodity price index interest rates and expanding price-earnings multiples (or chronic
traded between 1.25 and 2.5 times. Recently, gold traded at more valuation-driven markets). However, since short-term rates are zero
than four times the CRB index! The price of gold surged on safe- and long-term yields are close to record lows, an interest rate-driven
haven demands during the worst of the crisis. While most markets stock market is not in the immediate future. Fortunately, earnings
have since reversed crisis safe-haven premiums or discounts (e.g., appear set for a significant period of growth.
Treasury bonds, U.S. dollar, junk bonds, cyclical stocks, etc.), the
price of gold has never relinquished its crisis premium. Why? It Is there a precedent for an “earnings-driven stock market from
is possible the crisis safe-haven premium has been replaced by a average valuations”? Yes! The price-earnings multiple was
postcrisis inflation premium. However, we believe investments average to above average throughout the 1960s decade, and
based on either a deflationary meltdown or an inflationary blowoff yet despite no push from improved valuation, the stock market
will prove disappointing. persistently rose in-line with earnings. Then, as now, both inflation
and interest rates were very low and stayed dormant during much
May “Buy-And-Hold” R.I.P.!!!? of the 1960s. Also, the price-earnings multiple was only average
The 2008 crisis killed the “buy-and-hold” mantra of investing! and stocks still managed a solid run in-line with corporate profits.
It left investors with zero returns for more than a decade and To be sure, there are many, many differences between today and
has consequently raised the popularity of “market-timing.” This the early-1960s (e.g., debt is lower, savings is higher, and domestic
popularity switch between buy-and-hold and market-timing is an demographics is younger, but there was also no “emerging world,”
old one. By the end of WWII after about 15 years of malaise in no surge in free-market capitalism breaking around the globe over
the U.S. stock market, very few investors even wanted to touch the previous decade, and not nearly as much “dry powder cash”
stocks! However, for the next 20 years, the stock market embarked parked on the sidelines as today), but the crucial similarities of
on the best buy-and-hold investment era in its history. As a result, earnings growth potential, stable price inflation, and low interest
by the end of the 1960s, nearly everyone bought “good company rates do present some potential similarity. While the next few
stocks” and simply held them. After all, such an approach had years will not be exactly like the 1960s, the possibility of another
worked well for almost two decades. Indeed, the “Nifty Fifty” earnings-driven stock market is worth consideration.
market demise in the early 1970s was essentially the collapse in
the “good buy-and-hold company stocks” everyone bought at the Stay Bullish!!!
end of the 1960s! The economy has just exited recession and the stock market rally
is not likely to end this early in a fresh economic recovery. Policy
By the early-1980s, after more than a decade of flat and volatile officials have yet to begin reversing easing policies, positive job
stock prices, market-timing was all the rage, just in time for a creation has yet to start, consumer confidence is only back to
record-setting 20-year bull market run where only market-timers previous recession lows, and corporate profits have just begun
lost money! By the late 1990s, “buying and holding technology to improve. Interest rates are still too low for an economy about
companies” was a sure thing. After all, we were in a “new-era” to again embark on solid real growth. There is still too much
that would drive stocks higher forever! Today, after a decade pessimism, too many widespread doubts about the recovery, and
of stock market blues and after the worst financial panic in the a strong consensus belief in a potential double-dip recession. And,
postwar era, “buy-and-hold” is again dead! Most believe the because of these fears, there is still too much cash on the sidelines.
“world will never again be the same,” and investors should The stock market may already be up significantly from its crisis
prepare for profiting from volatile and trendless markets by low in early March but is still probably far below the peak it will
adopting strict “trading rules.” Anyone see a pattern here? Our ultimately reach during the unfolding economic recovery.
guess is, after more than 10 years of market malaise, buy-and-
hold may once again be on the cusp of proving a great investment
strategy.
An Earnings-Driven, à la 1960s–Style Bull
Market??? James W. Paulsen, Ph.D.
Chief Investment Strategist, Wells Capital Management
We believe this stock market recovery will prove an “earnings-
driven” event. Because of the excessive fears created during the
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4. Economic & Market Perspective
Monetary Worry!??!
The aggressive policy response to this crisis has created factor will certainly be whether the surge in money growth
widespread future inflation angst. As illustrated in the top during the last year proves temporary and is quickly reversed
chart, the annual M2 money supply has risen about 8 percent or whether it becomes imbedded and raises the long-term
in the last year—a strong pace by long-term historical monetary growth rate (dotted line). The lower chart shows
standards. However, the four-year annualized growth in the the relationship between money growth and inflation is far
M2 money supply remains much more modest and appears from perfect. The U.S. has experienced several prolonged
much less worrisome. While money supply growth in the last periods during the last 120 years where monetary growth was
year is comparable to the high inflation in the 1970s, it also is excessive, and yet material inflation did not materialize. No
no stronger than earlier this decade! Whether the response of doubt inflation risk has been elevated by very accommodative
monetary officials to this crisis leads to an eventual inflation policies and will demand ongoing consideration as the
problem depends on many factors (e.g., speed and strength of economic recovery matures. At this point, however, a
the recovery, global growth, dollar weakness, Fed responses, significant rise in inflation is far from certain!??
and bond vigilante reaction, to highlight a few). A primary
M2 Money Supply Growth
Annual Growth Rate (Solid)
4-Year Average Annualized Growth Rate (Dotted)
Inflation vs. Money Supply Growth
Annual Consumer Price Inflation Rate (Solid)
Annual Growth in M2 Money Supply (Dotted)
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5. September 2009
Five Reasons to Expect “Better–than–Expected” Growth!?!?
Five key forces are likely to produce an economic recovery coming of the Great Depression by purging inventories,
that continues to outpace consensus expectation. First, the payrolls, and capital spending programs. If, rather than a
policy response to this crisis has been massive and most depression, a U.S. recovery is unfolding, businesses will be
of it introduced only since the Lehman collapse one year forced to engage in a lot of “purge reversals”—rebuilding
ago. Economic policies have various lag times (average is inventories, rehiring workers, and recommitting to projects
about one year) before they begin to show economic impact. earlier canceled. Third, although confidence has improved
Consequently, favorable impact from the aggressive policy from when depression fears were widespread earlier this year,
stimulus is just now beginning to show up on Main Street. it should still rise substantially more as the recovery matures!
Second, U.S. businesses have been preparing for the second
Trailing 12-Month Federal Deficit Annual Growth in M2 Money Supply
Billions U.S. Dollars
Change in Real Business Inventories NonFarm Payroll Employment New Orders for Capital Goods
Conference Board Consumer Confidence Index
Natural Log Scale
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6. Economic & Market Perspective
“Better–than–Expected” Growth ... Continued!!??
Fourth, the housing and auto sectors have been chronically been problematic for the recovery, have stalled in the last few
“subtracting” from U.S. growth for much of the last couple months, even though economic reports have improved. The
of years. Even if these two sectors simply bottom, it will longer these two negatives remain range bound, the more time
“add” to overall real GDP growth via “addition by less this recovery can mature, gain strength, and achieve solid
subtraction”! More likely, as these charts suggest, housing footing. Massive policy stimulus, the corporate purge reversal,
and autos will likely expand some in the coming year, directly improving economy-wide confidence, a bottoming in housing
adding to overall growth. Finally, two negative forces—rising and autos, and the muting of negative forces should allow real
mortgage rates and surging energy prices—that could have GDP growth to surpass expectations in the coming year!??!
Single Family U.S. Housing Starts Bankrate’s National Average 30-Year Mortgage
Crude Oil Futures Price Total Annualized U.S. Auto Sales
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7. September 2009
Too Early to Evaluate the Consumer!???
In our view, it is too early to evaluate whether the U.S. though jobs have declined at an annualized rate of about 5
consumer is responding to stimulus and will soon spend percent, real consumption has risen slightly! While this does
again, or whether they will simply enhance savings and lower not prove the U.S. consumer is healthy and robust, it also
debt burdens. Many are looking at contemporary reports on doesn’t suggest they are DOA! We are also encouraged by
consumer spending as evidence the consumer is dead and will the response of household spending to “good deals.” The
not be a force for growth in this recovery. Why, though, should Cash for Clunkers program and housing sales based on falling
current spending trends be positive when job losses are still foreclosure prices suggest the rumors of household death
pronounced and private income trends are still contracting? may be greatly exaggerated! Perhaps the U.S. consumer will
We do not expect to see robust, or even moderately healthy, prove very lethargic in the coming recovery. Perhaps not! We
consumer spending “until” job creation returns. As these charts believe a couple of quarters of positive real GDP growth and a
show, consumer spending has actually been stronger than return to job creation will be necessary before judgment on the
expected considering the collapse in job creation. Historically, future of U.S. households can be accessed. And, we suspect
real consumption growth has been about 2 to 3 percent many will again be surprised by the revival in the old “spendy
faster than job growth. In the last six months, however, even culture” of the U.S. consumer?!?!
Real Consumer Spending Growth vs. Job Growth
Annualized 6-Month growth in real personal consumption expenditures (Solid)
Annualized 6-Month growth in nonfarm payroll employment (Dotted)
Real Consumption Growth Less Job Growth
6-Month Annualized Growth Differential
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8. Economic & Market Perspective
Best News for Jobs ... PROFITS!!?
It takes profits to produce jobs and profits have again been Every time since at least 1960, when profit per job has risen
rising! Total U.S. corporate profits have risen in each of the by this much, nonfarm payroll employment has bottomed or
first two quarters this year at almost a 23 percent annualized was very close to a bottom. We expect profits to continue
pace! The solid line in this chart shows the profit per job to rise in the next several quarters and therefore believe job
which has risen by more than 14 percent since year-end! creation will soon return?!??
Profit Per Job vs. NonFarm Payroll Employment
NonFarm Payroll Employment Natural Log Scale,
Corporate Profit Per NonFarm Payroll Job,
Natural Log Scale (Solid)
Millions (Dotted)
“Half-Empty” ... OR ... “Half-Full”!!??
This crisis has produced a “half-empty” sentiment. While in the world that should be considered alongside the anxieties
certainly there are significant headwinds and problems to of the day. We offer this partial list of the day’s major concerns
worry over, there are also some surprisingly favorable trends with some underappreciated newfound global assets!??
Most Seem Focused On: But Ignore:
• Overindebted/Undersaved U.S. Consumer? • Newfound Oversaved/Low Debt
Emerging World Consumers!
• Aging Developed World Demographics? • Young Emerging World Demographics
with Ballooning Desires!
• Leftward Shift in U.S. Politics/Economy? • Surge in Free-Market Capitalism around
the Globe in Last 10-15 Years!
• Only Average U.S. Equity Valuations? • U.S. near Price Stability (core inflation ~1 percent)
with Record-Low Interest Rates!
• Fear/Lack of Animal Spirits? • Massive “Dry Powder”
on the Sidelines!
• A Weak U.S. Dollar? • An Improving U.S. Global
Competitive Position!
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9. September 2009
It’s a Low, Low, Low Rate World!!!?
U.S. interest rates are extraordinarily low. This may be if the economy starts to grow again and job creation returns,
appropriate if the world is indeed close to depression. However, how long will borrowing remain anemic with an interest rate
it is worth considering how this page would look one year structure priced for a prolonged depression? How much and
from now if the economy recovers and real GDP grows 3 to 4 for how long can real GDP advance before this interest rate
percent! Borrowing propensities may currently be weak, but structure simply becomes absurd??? Just food for thought!!??
30-Year Conventional Mortgage Rate Moody’s A Corporate Bond Yield
U.S. Municipal Bond Yield* 10-Year U.S. Treasury Bond Yield
*Bond Buyer 20 GO Bond Index
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10. Economic & Market Perspective
Cloning the U.S. Consumer!?!!
For the last 10 years, the U.S. has been busy investing in The U.S. has essentially cloned itself in the emerging world!
the emerging world, attempting to manufacture newfound This new consumer force, however, is much younger with
consumers that can carry global economic growth for the next burgeoning desires, low debt, and high savings! Indeed,
generation. OK, this wasn’t a conscious effort, but the early in recent years, U.S. dollar-based consumption from the
results are nonetheless encouraging. Why are U.S. households emerging world has been growing more than twice as fast
so undersaved and overindebted? Partly because a large part of as consumption in the U.S. The lower chart challenges the
household spending in the last decade leaked abroad (through widespread idea that consumers in this part of the world are
a ballooning trade deficit), and rather than creating jobs and not yet really a meaningful force. The share of total global
income here, it did so in emerging worlds. Consequently, U.S. dollar-based imports comprised by the emerging world
even though the U.S. consumer may be somewhat impaired “headliners” (i.e., China, India, and Mexico) has risen to
after so many years of spending in excess of its income, about 11 percent—more than double its level one decade
newfound emerging world consumers may help take up the ago! Perhaps the U.S. consumer is no longer up to the task
slack! Ten years ago, the U.S. dollar level of emerging world of leading global growth, but their “overspending” in recent
consumption was only slightly more than one-half that of the years has created a brand new global asset (i.e., newfound
U.S. consumer. Today, the dollar spending of emerging world emerging world consumers) which may be able to fill (or at
consumers is almost on par with U.S. households! Amazing! least significantly reduce) the gap!???
Total Private Consumption Expenditures in U.S. Dollars Annual Growth in U.S. Dollar Total Private Consumption
Emerging Market Economies* as a Percent of U.S. Emerging Economies* vs. U.S.
Emerging World “Headliner” Imports
as a Percent of Total World Imports*
*Imports from China, India, and Mexico as a percent of
total world imports.
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11. September 2009
The U.S. Dollar Likely to Weaken against Emerging Country
Currencies ... And it Should!!!!
After surging on safe-haven demands during the worst of the have similar economic problems (e.g., overindebtedness,
crisis, the U.S. dollar has steadily weakened since the financial aging demographics, and in need of new sources of economic
markets and the economy have shown increasing signs of growth). None of them can, nor will, allow others to devalue
recovery. In the top chart, the dotted line illustrates the trade- and steal coveted growth. Consequently, pressure to maintain
weighted U.S. dollar index against 10 of its largest developed currency parity will soon effectively peg developed world
trading partners. The dotted line is a Trade-Weighted emerging currencies within a narrow band. However, we also believe
world U.S. dollar index. It is comprised by the 22 countries most developed world currencies (including the U.S. dollar)
that are included in the Morgan Stanley Emerging Market will continue to devalue slowly during the next decade against
Stock Index. Both currency measures have moved roughly emerging world currencies. Emerging countries possess
together in the last decade, but not perfectly. The U.S. dollar stronger inherent growth possibilities and also have currencies
strengthened against both until the early 2000s, then mostly that are mostly woefully and artificially undervalued. On
weakened until the 2008 crisis spike and have weakened average, since 2002, the emerging world U.S. dollar index has
again since early 2009. However, U.S. dollar strength against risen by almost 40 percent relative to the U.S. dollar developed
developed world currencies peaked in early 2002, whereas the world index. Therefore, emerging currencies are undervalued
U.S. dollar did not peak against emerging currencies until late and are set to undergo a prolonged period of appreciation
2004! Moreover, while the developed world dollar index is against the U.S. dollar (and other developed world currencies).
currently close to breaking to new decade-lows, the emerging The lower chart shows that the weakness in the emerging
dollar index is actually higher today than it was in early 2002 currency index between 2005 and 2008 was beginning to
when the developed U.S. currency index peaked! We think pay U.S. dividends. The trade deficit with emerging markets
both businesses and investors should recognize how these two has been improving for the first time in more than a decade.
U.S. dollar exchange rate trends are changing. While the U.S. Since this deficit is about $400 billion, renewed U.S. dollar
dollar probably will weaken further in the next few months, weakness against these parts of the world could continue to
we expect developed world currencies to soon essentially add significantly to overall U.S. real GDP growth!??!
(and unofficially) lock together. Most developed countries
U.S. Trade-Weighted Emerging Market Dollar Index vs. U.S.
Trade-Weighted Developed Country Index*
*The DXY Index based on largest 10 trading partners.
Current Weights:
Emerging Market Currency Index
Brazil 4.56%
China 31.62%
Colombia 1.68%
Egypt 0.88%
Hungary 0.33%
India 3.09%
Indonesia 1.57%
Korea 6.03%
U.S. Emerging Markets** Trade Balance Mexico 26.96%
**Trailing 12-Month sum of monthly net exports with the 22 countries Poland 0.47%
comprising the Morgan Stanley Emerging Market Stock Price Index. Russia 2.83%
Value is in Billions of U.S. Dollars South Africa 2.84%
Taiwan 4.22%
Chile 1.45%
Czech Rep 0.28%
Israel 2.58%
Malaysia 2.97%
Morocco 0.18%
Peru 0.86%
Philippines 1.17%
Thailand 2.35%
Turkey 1.07%
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12. Economic & Market Perspective
May “Buy–and–Hold” R.I.P.!??!
The 2008 crisis killed the “buy-and-hold” mantra of investing! all, such an approach had worked well for almost two decades.
The buy-and-hold strategy has left investors with zero returns However, the nation was on the doorstep of nearly 15 years,
for more than a decade and has raised the popularity of whereby the stock market would be flat and volatile! By the
“market-timing.” This popularity switch between buy-and- early 1980s, market-timing was all the rage, as was buying
hold and market-timing is an old one. By the end of WWII and holding tech stocks in 1999! Today, it is widely believed
after about 15 years of malaise in the U.S. stock market, very the “world will never again be the same” and “buy-and-hold”
few investors even wanted to touch stocks! However, the is dead! Our guess, however, is after more than 10 years of
country was on the cusp of the best buy-and-hold investment market malaise, buy-and-hold may once again prove a great
era in its history! By the end of the 1960s, nearly everyone strategy in the coming decade??!!
bought “good company stocks” and simply held them. After
U.S. Stock Market
Shown on a Natural Log Scale.
Both Gold and Oil Look too High!???
Oil has been popular throughout this decade and gold has do in the next several years, but as these charts show, in
recently become “the inflation solution for policy official relation to overall commodity prices, both gold and oil prices
crisis overeasing”! Who knows what these investments may look very expensive!??!
Relative Price of Gold Relative Price of Crude Oil
Price of Gold Divided by CRB Commodity Price Index Price of Oil Divided by CRB Commodity Price Index
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13. September 2009
Right after the Lehman Collapse ... It Paid to Take Risk!!??
Immediately “after” the Lehman crash one year ago, when most perceive risk as being high, the reality is risk is
widespread bearishness spiked! However, as these charts actually low! The time to begin buying risk assets was when
suggest, within about one month after the Lehman collapse, most were giving them away! A renewed bull market rally (led
the appropriate thing for investors to do was to adopt bullish by risk assets) began almost coincidently as the worst crisis
investments. Some of the most cyclical stock sectors (e.g., carnage finally hit Main Street! While the prospective return
technology, materials, small caps, and emerging market stocks) possibilities are no longer as great as they were last November,
and aggressive investments (like commodities and junk bonds) we still think risk assets offer investors solid prospects, in part
began outpacing market returns in November of 2008! Often because confidence is still low and fears are still elevated!??
S&P 500 Information Technology Sector S&P 500 Materials Sector
Relative Stock Price Performance Relative Stock Price Performance
Morgan Stanley’s Emerging Market Index CRB Raw Industrial Commodity Price Index
Relative Stock Price Performance Shown on a Natural Log Scale.
Russell 2000 Small Cap Index Junk Bonds vs. Treasury Bonds
Relative Stock Price Performance Ratio of Relative Total Return Indexes*
*BarCap U.S. Corporate High Yield TR divided by BarCap U.S.
Treasury 7-10 Year TR
| 13 |

14. Economic & Market Perspective
Stocks Need to “Catch Up” to Profits!???
The solid line illustrates the relative price performance of relative performance of stocks compared to bonds did not!
stocks above bonds. The dotted line shows the total level of However, profits have bottomed in this recession at a level
U.S. corporate profits. Over time, it should not be surprising slightly above its previous cycle peak in 2000. That is, the
that these two series tend to move together. Typically, as long secular trend in profitability appears to be intact. Why
profits rise to new highs, so does the relative performance has the relative performance of stocks seemingly become
of stocks! From 1960 until 2000, U.S. profits achieved disconnected from corporate profit results? Excessive
four major new all-time highs that were matched by four Fears? We don’t know the answer, but find this disconnect
new all-time highs in the relative performance of the stock interesting. Is it a harbinger of bad times to come? Or, an
market (above bonds). However, in this decade, even though indication of forthcoming potentially strong stock returns???!
profits surged ahead to another new all-time high, the
Relative Stock/Bond Ratio vs. Real Corporate Profits*
Inflation-Adjusted Total U.S. Corporate Profits*
S&P 500 divided by 10-Year Treasury Bond Price.
Relative Price Performance of Stocks vs. Bonds.
Natural Log Scale. (Dotted)
Natural Log Scale. (Solid)
Rising Confidence Should Push Stock Prices Higher??!
As this chart illustrates, stock prices and confidence tend to be likely rise as the recovery matures. Since confidence still has
closely related. Even though confidence throughout the economy considerable room for further improvement, so does the stock
has begun to improve, it still remains extremely low (only market!!! It won’t be a straight line, but stay Bullish!!!
just now back to cycle lows during the last 40 years) and will
Consumer Confidence vs. Stock Market Growth
Conference Board Consumer Confidence Index (Solid)
S&P 500 Stock Price Index: Annual Growth (Dotted)
| 14 |

15. September 2009
Will Velocity Turn???!
Borrowing velocity (i.e., the rate at which money supply the right chart, until the 1990s, money supply growth (dotted
creates new borrowing) has fallen significantly in this line) tended to lead borrowing growth. Since 1990, however,
recession. However, as the left chart shows, the depth and borrowing has led monetary growth. So, what will it be? Is
rate of decline in private-sector borrowing velocity is no the surge in the money supply in the last couple of years a
worse in the contemporary crisis than it was during the 1970s. precursor to a revival in borrowing (à la 1960 to 1990) or is
This velocity chart does not yet show any watershed shift the decline in borrowing (solid line) suggesting an impending
in borrowing propensities, although an abnormal velocity collapse in the U.S. money supply? We’ll be watching?!?!?
recovery could certainly still come to pass. As illustrated in
Private-Sector Borrowing-Money Supply Velocity* Private Debt vs. Money Supply
*Total Household and Business Sector Debt Outstanding divided by M2 Annual Growth in Total Household and Business Debt (Solid)
Money Supply. Shown on a natural log scale. Annual Growth in M2 Money Supply (Dotted)
| 15 |

16. Economic & Market Perspective
An Earnings-Driven, à la 1960s–Style, Bull Market???
We believe the unfolding recovery in the stock market will traded at 15 times (an average valuation similar to today), and
prove mostly an “earnings-driven” event. Due to excessive it traded at or above this level throughout much of the 1960s.
fears during this recession, businesses have become extremely Consequently, the 1960s stock market gains had little to do
lean and mean, focused on boosting efficiencies and enhancing with valuation improvement, but rather was almost entirely
productivities. Consequently, the business sector possesses tied to earnings growth. This was made possible because first,
considerable profit leverage. Is there a precedent for an earnings grew, and second, both inflation and yields remained
“earnings-driven stock market from average valuations”? Yes! stable. Could this happen again in the developing recovery?
The stock market run during the 1960s! Then, as now, both We think so! Inflation typically declines for one or two years
inflation and interest rates were very low and stayed dormant “after” a recession ends, which implies inflation should remain
during much of the 1960s. Also, the price-earnings multiple well-controlled during the next couple of years. Moreover,
was only average, and yet still, the stock market managed a yields have already adjusted for no depression, and while they
solid run in-line with corporate profits. In the top chart, the may rise some as recovery (real GDP growth) takes hold, they
solid line is the S&P 500 stock price index and the dotted are not likely to rise significantly unless inflation surges. In
line is the level of trailing earnings per share. The chart is the next few years, we expect inflation and yields to remain
constructed so when the S&P 500 price line (the solid line) low and stable while earnings surprise to the upside perhaps
touches earnings (dotted line), the stock market is selling for producing a stock market rally à la 1960s-style??!!
15 times trailing earnings. In the late 1950s, the S&P 500
S&P 500 Composite Stock Index Price vs. Earnings*
1958–1970
S&P Stock Price Index shown on a natural log scale (Solid)
Trailing 12-Month earnings per share, 3-Month moving average (Dotted)
10-Year Treasury Yield vs. Consumer Price Inflation
1958–1970
U.S. 10-Year Treasury Yield (Solid)
Annual U.S. Consumer Price Inflation Rate (Dotted)
Wells Capital Management (WellsCap) is a registered investment adviser and a wholly owned subsidiary of Wells Fargo Bank, N.A. WellsCap provides investment management services for a variety of institutions.
The views expressed are those of the author at the time of writing and are subject to change. This material has been distributed for educational purposes only, and should not be considered as investment advice
or a recommendation for any particular security, strategy or investment product. The material is based upon information the author considers reliable, but its accuracy and completeness cannot be guaranteed. Past
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Written by James W. Paulsen, Ph.D. 612.667.5489 | For distribution changes call 415.222.1706 | www.wellscap.com | ©2009 Wells Capital Management