Wells Capital Management

Perspective

Economic and Market

Bringing you national and global economic trends for more than 30 years

April 13, 2016

A new high for the stock market?

No deflationary abyss?
James W. Paulsen, Ph.D
Chief Investment Strategist,
Wells Capital Management, Inc.

It has been a difficult couple years for the stock market.

Currently, a litany of concerns are weighing on investors
minds including high valuations, an earnings reporting season
beginning this week destined to be lousy, a very weak first
quarter U.S. real GDP number, continued evidence of sluggish
economic growth about the globe, monetary policies which
increasingly appear overextended, ineffective, and scary
(negative interest rates?), and a process aimed at picking the
next leader of the free world which oddly is both entertaining
and frightening (and yes, Panama papers, Brexit, ISIL, and North
Korean missile tests).
We continue to expect a relatively flat stock market this year
with the S&P 500 ranging from about 1800 to 2200 and ending
the year about where it started at 2050. We are also mindful
that predicting short-term stock market movements are often a
fools game and consequently only worthy of marginal portfolio
adjustments. However, currently, we suspect the stock market
may soon break to new record highs near the upper end of our
forecasted trading range. Several forces could help improve
near-term momentum in the stock market. First, the deflationary
undertone dominating investor mindsets in the last couple
years seems finally to be easing as commodity prices show
signs of recovery. Second, some factors now suggest earnings
performance may begin to improve during the balance of this
year. Third, economic surprise indexes recently show that global
economic momentum may be headed for a synchronized
bounce. Finally, fear is increasingly evident in the stock market
reestablishing the bedrock of this bull market climbing a
perpetual wall of worry!

As illustrated in Exhibit 1, the persistent deflationary decline in

commodity prices since mid-2014 may finally be ending. First,
from its February low, the price of crude oil has jumped by the
largest percentage amount since the current deflationary spiral
began. Moreover, the WTI spot crude oil price is currently slightly
above $40 and only about 10% below where it was in early
January 2015. That is, rather than collapsing as it did in 2014, the
price of oil has shown signs of bottoming since early 2015.
Second, and perhaps most important, is the recent significant
surge in raw industrial commodity prices. The CRB Raw Industrial
Commodity Price Index has risen by about 12.5% from its
low in late November. This is the largest increase in industrial
prices since commodity prices peaked and it is indeed a very
encouraging sign that those prices most sensitive to economic
activity (i.e., industrial commodity prices) have been rising now
for the last four to five months!
Third, U.S. dollar strength has been at the epicenter of the
collapse in commodity prices and it is no coincidence commodity
prices bottomed earlier this year when the broad U.S. dollar
peaked. The U.S. dollar has recently suffered its largest pullback
against both developed and emerging currencies since
commodity prices peaked and we expect the dollar to continue
to weaken during the balance of this year.
Fourth, the significant jump in international freight rates suggest
deflation pressures may also be easing about the globe. Is U.S.
importation of deflationary pressures coming to an end?
Finally, as shown in Exhibit 2, U.S. core cost pressures are no
longer decelerating. Both core consumer price and wage inflation
have accelerated significantly in the last year consistent with the
economy returning to full employment.

Economic and Market Perspective | April 13, 2016

Exhibit 1: Commodity deflation ending?

Chart 1

Chart 2

WTI spot crude oil price

Natual log scale

CRB/Reuters Spot Raw Industrial Commodity Price Index

Natual log scale

Chart 3

Chart 4

U.S. Broad Trade-Weighted Dollar Index

Natural log scale

Baltic Freight Rate Index

Natural log scale

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Economic and Market Perspective | April 13, 2016

Exhibit 2: Core consumer and wage inflation accelerating?

Chart 1
Wage and core consumer price inflation rate
Solid U.S. annual wage inflation rate (three-month
moving average)
Dotted U.S. core consumer annual inflation rate

In the last couple years, deflation has weighed heavily on the

financial markets. A strong U.S. dollar and weak commodity
prices have heightened investor concerns regarding a potential
global deflationary abyss, led foreign officials to adopt negative
interest rate policies and forced the U.S. Fed to pause tightening
plans, depressed corporate earnings results, lowered inflation
expectations, widened corporate bond yields spreads, and
contributed to persistent declines in equity mutual fund flows.
In short, deflation and fear of deflation has shaped investor
behaviors. If this primary trend of the last couple years is
finally ending, investor attitudes and actions could become
much more aggressive and optimistic. If commodity prices are
indeed bottoming, will risk-on once again become vogue, will
earnings expectations accelerate, will equity fund flows improve,
and will stock market leadership shift from defensive toward
cyclical sectors?

An earnings rebound?
Since late 2014, S&P 500 earnings have increasingly disappointed
investor expectations. Although first quarter earnings are likely
to decline significantly, we expect earnings results to improve
during the balance of this year.

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First, as shown in Exhibit 3, consensus earnings expectations

have been lowered considerably since year end. Indeed,
earnings expectations have declined steadily for much of the
last year. Most investors are hunkered down for a disastrous
first quarter earnings season which may already be mostly
discounted by the stock market. That is, since expectations have
already adjusted downward so much, even bad earnings may
prove better than feared.
Second, as shown by the other two charts in Exhibit 3, recent
weakness in the U.S. dollar and a revival in industrial commodity
prices suggest S&P earnings are likely to improve during the
rest of 2016. As shown, changes in the Broad U.S. Dollar Index
and changes in the movements of industrial commodity prices
have tended to lead changes in the pace of earnings growth.
The annual growth of the U.S. dollar peaked last August at
around 15% and has since slowed to only about a 4% annual
gain. Likewise, industrial commodity prices have been rising
again since last November. With a lag of several months, the
combination of a weaker U.S. dollar and stronger industrial
prices should lead to faster growth in S&P 500 earnings per share
during the last half of this year.

Economic and Market Perspective | April 13, 2016

Exhibit 3: Will S&P 500 earning performance prove better than feared?
Chart 1
S&P 500 consenses estimated 2016 earnings per share*
*Source: Bloomberg

Chart 3

Chart 2
S&P 500 EPS vs. industrial commodity prices
Solid (left scale) Annual growth in trailing 12-month
S&P 500 earnings per share
Dotted (right scale) Annual growth in U.S. Broad
Trade-Weighted Dollar Index (inverted scale)

S&P 500 EPS vs. industrial commodity prices

Solid (left scale) S&P 500 trailing 12-month earnings
per share, natural log scale
Dotted (right scale) CRB/Reuters Raw Industrial Spot
Commodity Price Index, natual log scale

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Economic and Market Perspective | April 13, 2016

A synchronized global economic pop?

The selloffs in 2014 and 2015 were widely considered a temporary

pause in an ongoing bull market, a good buying opportunity and
a refreshing correction. Both times the stock market recovered
quickly and fearful investor behaviors never fully emerged. That
is, there was not a wholesale rush to the safe-haven Treasury
bond, to gold, or toward defensive stocks.

Rarely, in this global economic recovery, have all the economic

boats been headed higher together. However, as the charts in
Exhibit 4 and Exhibit 5 illustrate, economies about the globe
recently appear to be gathering upside momentum at the same
time. Recently, economic surprise indexes have simultaneously
been trending higher among most developed economies (e.g.,
U.S., U.K., eurozone, and Canada) and in emerging economies.

The third correction in 17 months, (in January), however, broke

investor calm. The S&P 500 Index established new lower lows
and instantly the commentary surrounding the 2016 correction
sounded more fearful. Few were any longer suggesting it
was a refreshing pause. Rather, calls arose for a bear market,
an imminent recession, a growing risk of a global financial
contagion, and perhaps even a deflationary abyss. More
importantly, unlike the corrections in 2014 or 2015, in January,
investor behaviors turned decidedly bearish. As shown in Exhibits
6 and 7, investors have recently rushed to safe-haven Treasury
bonds, gold, and the yen. They have dumped risky junk bonds
and cyclical stocks in favor of defensive and risk adverse staples
stocks and high quality dividend payers. Finally (not shown),
liquidations from equity mutual funds have recently increased
significantly.

Perhaps the world economy is finally beginning to respond to

the extensive synchronized global stimulus introduced in the last
18 months (i.e., a global fiscal tax cut in the form of a collapse in
commodity prices, a massive drop in most long-term sovereign
bond yields, and a major currency devaluation against the U.S.
dollar). A synchronized global economic pop (perhaps the first
since the very start of this recovery), even if all are only growing
slowly, could convince investors that the bull market is resuming.
Indeed, this attitude could become pronounced should the
global economy experience a synchronized bounce while
commodity prices bottom and S&P 500 earnings improve.

Climbing a wall of worry?

For most of this bull market, the primary foundation has been
fear climbing a chronic wall of worry. This was certainly the
case when the bull market began in March 2009 and worries
persisted as a cascade of Armageddons were imagined including
the potential for another major bank failure, a secondary
housing crisis, a massive municipal bond default, going over the
fiscal cliff, stress tests, and a blow apart of the eurozone. Mixed
in were concerns about Washington gridlock, ISIL, no wage
growth, hitting the 2% economic stall speed, and policy officials
pushing on a string.
Indeed, in the contemporary bull market, it was not until 2014
after the stock market had risen steadily for almost three years
that the consensus outlook finally calmed. And, once the stock
market lost its primary foundation, fear, it has since struggled.
The S&P 500 has recently suffered three significant corrections
(while the first was just shy of the 10% correction definition, two
others exceeded 10%), including one in September 2014, another
in August 2015, and finally again in January 2016. During the first
two corrections, consensus investor attitudes remained sanguine.

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In sum, what the corrections of 2014 and 2015 could not do, the
2016 correction has accomplished. For the first time in a couple
years, it has brought back that which made this bull market
great fear!

Economic and Market Perspective | April 13, 2016

Exhibit 4: Developed economies are bouncing?

Chart 1

Chart 2

U.S. Citigroup Economic Surprise Index

Eurozone Citigroup Economic Surprise Index

Chart 3

Chart 4

United Kingdom Citigroup Economic Surprise Index

Canada Citigroup Economic Surprise Index

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Economic and Market Perspective | April 13, 2016

Exhibit 5: Emerging economies also bouncing?

Chart 1
China Citigroup Economic Surprise Index

Chart 2
Emerging markets Citigroup Economic Surprise Index

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Economic and Market Perspective | April 13, 2016

Exhibit 6: A rush to safe havens?

Chart 1
10-year U.S. Treasury bond yield

Chart 2

Chart 3

Japanese yen exchange rate

Price of one U.S. dollar in yen

Price of spot gold

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Economic and Market Perspective | April 13, 2016

Exhibit 7: Defensive investor behaviors?

Chart 1
S&P 500 Consumer Staples Sector Relative Price Index

Chart 2

Chart 3

S&P 500 Dividends Aristocrats Relative Total Return Index

J.P. Morgan junk bond index yield spread

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Economic and Market Perspective | April 13, 2016

Summary and conclusions

It is very difficult to correctly predict short-term stock market
swings. Indeed, we have far more confidence in our call for a
broad trading range this year between about 1800 and 2200
ending the year roughly flat than we do that the next move for
this stock market is to establish new record highs.
However, we think investors could consider marginally tilting
portfolios toward a risk-on posture anticipating the possibility
stocks may be headed for a rally. Four positive forces may be
coming together which could heighten investor optimism. First,
the deflationary undertone dominating investor mindsets in the
last couple years seems finally to be easing as commodity prices
show signs of recovery.
Second, significantly lowered earnings expectations seem
poised to be surpassed in the last half of this year. Third, global
economies may experience the first synchronized economic
pop of this recovery. Lastly, an old friend of this bull market,
fear, has returned.

Written by James W. Paulsen, Ph.D.

An investment management industry professional since 1983, Jim is
nationally recognized for his views on the economy and frequently
appears on several CNBC and Bloomberg Television programs, including
regular appearances as a guest host on CNBC. BusinessWeek named him
Top Economic Forecaster, and BondWeek twice named him Interest Rate
Forecaster of the Year. For more than 30 years, Jim has published his
own commentary assessing economic and market trends through his
newsletter, Economic and Market Perspective, which was named one of
101 Things Every Investor Should Know by Money magazine.

Wells Fargo Asset Management (WFAM) is a trade name used by the asset management businesses of Wells Fargo & Company. WFAM includes Affiliated Managers (Galliard Capital Management, Inc.; Golden Capital
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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/informational 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 we consider reliable, but its accuracy and completeness cannot be
guaranteed. Past performance is not a guarantee of future returns. As with any investment vehicle, there is a potential for profit as well as the possibility of loss. For additional information on Wells Capital
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