Wells Capital Management

Perspective

Economic and Market

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

August 8, 2016

Stock investors should look a yonder

James W. Paulsen, Ph.D
Chief Investment Strategist,
Wells Capital Management, Inc.

We think the global economic recovery may be in the early

stages of a synchronized bounce. While we suspect the overall
pace of economic growth will likely remain subpar by historic
standards, the global recovery appears poised to broaden.
That is, for one of the rare times in this recovery, perhaps most
economies about the globe will bounce northward together.
Recently, somewhat better economic reports have already
helped elevate stock prices about the globe including
pushing the U.S. stock market to new record highs.
However, if evidence of a global economic bounce broadens,
it is likely to help international stocks much more compared
to domestic stocks. For several reasons, we think investors
should consider a near maximal overweight toward both
ex-U.S. developed and emerging stock markets. International
stock markets have underperformed for some time and
consequently most are now significantly under-owned and
represent better values relative to U.S. stocks. Additionally,
only the more mature U.S. economic recovery now faces
the challenges associated with returning close to full
employment. Consequently, most international stock markets
will continue to be supported by hospitable policy actions
whereas U.S. officials are beginning to turn hostile for the
stock market. Moreover, the U.S. dollar has peaked in the
last year and appears likely to weaken in the coming year.
Finally, and perhaps most importantly, compared to an aging
earnings cycle in the U.S., most international companies still
have the potential to achieve considerable earnings gains.

A global economic bounce?

After seven years of chronically disappointing economic
growth about the globe, in the immediate aftermath of
the current crisis de jour Brexit and in a world which now

boasts negative sovereign bond yields as commonplace, few

anticipate that the world economy may be on the brink of an
economic bounce.
However, for the first time in this recovery, all policy officials
are simultaneously pushing upward on the global economy.
Although the U.S. has persistently employed stimulus, other
developed and emerging economic policies have often been
in conflict. Today, though, Japanese policy officials are no
longer hesitant but rather are implementing full out Bernanke
stimulus. Likewise, the eurozone, which earlier adopted fiscal
tightening, has now also fully embraced central bank balance
sheet expansion. Moreover, the oil crisis has forced energybased economies like Canada and Australia to also become
accommodative. Finally, China (similar to other emerging
economies) is no longer attempting to moderate its recovery
as it was until 2015 but rather is using all weapons (a collapse
in its sovereign bond yield, a surge in the growth of its money
supply and a more aggressive yuan devaluation) to quicken
growth. Economic policies around the world are finally attuned
suggesting the odds of a synchronized global economic
bounce may be higher than ever before in this recovery.
Indeed, a global economic upturn may already be underway?
As illustrated in Chart 1, the Westpac Positive Surprise Global
Index has surged by its quickest and largest amount of
the entire recovery since March and now stands at its best
level in more than five years! An improvement in economic
momentum is also strongly suggested by rising stock
markets. Developed world stock markets are up by about 15%
to 20% and emerging stock markets have risen by almost
30% from early-year lows. Finally, commodity prices also
imply rebounding economic momentum with U.S. industrial
commodity prices up by about 20% from first quarter lows.

Economic and Market Perspective | August 8, 2016

Chart 1

Chart 2

Westpac Positive Surprise Global Index

U.S. S&P 500 Composite Stock Price Index, natural log scale

Four-week moving average

Trailing 12-month earnings per share vs. trendline average

A significant earnings rebound abroad?

Chart 3

As shown in Charts 2 and 3, corporate earnings have been

declining in the U.S. for the last couple of years and throughout
much of this recovery abroad. The trailing 12-month earnings
per share for the S&P 500 stock price index and the MSCI world
ex-U.S. stock price index are shown relative to their respective
trendlines since 1970.

MSCI World Ex-U.S. Stock Price Index, natural log scale

Trailing 12-month earnings per share vs. trendline average

Interestingly, in the last 45 years, both domestic and

international corporate earnings growth has been about the
same. Foreign earnings growth has averaged about 6.5%
per year compared to only slightly faster 6.8% U.S. earnings
growth. However, since early in this recovery, U.S. earnings
performance has far outpaced a worsening trend in foreign
profitability. While corporate performance about the globe has
struggled in the last couple of years, U.S. earnings have only
declined modestly to about 13% below trend and still reside
almost 20% above the peak during the last recovery in 2007. By
comparison, foreign earnings have declined almost 40% below
trend and are almost 45% lower than the record peak in 2008.

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Economic and Market Perspective | August 8, 2016

Although a synchronized global economic bounce would

boost earnings performance across the globe, there is
much more potential for a dramatic earnings rebound
outside of the U.S. The divergence between U.S. and
foreign earnings performance in this recovery has been
unique. At least since 1970, during global economic
recoveries, the earnings performance in the rest of the
world has never been this poor relative to profit results
in the U.S. Therefore, should the current global economy
finally broaden for the first time in this recovery, foreign
profits will likely improve significantly more compared to
U.S. company results.
As shown in Charts 4 and 5, foreign companies appear
to have greater potential to boost sales and to expand
profit margins relative to U.S. companies. While sales have
flattened for U.S. companies in the last couple of years,
they have collapsed among foreign companies. A bounce
in global economic activity would most likely boost
sales trends more abroad than within the U.S. Similarly,
while U.S. profit margins remain near all-time record
highs, foreign profit margins have considerable room for
improvement. Indeed, because the U.S. has returned close
to full employment, any boost in sales among U.S. companies
may be mostly offset by margin erosion since wages and
other costs are poised to accelerate.
Chart 6 is a simple reminder that what falls the most,
often rebounds the most. It overlays the percent by which
earnings among U.S. and foreign companies are above or
below their respective trendlines. Since 1970, this chart has
provided a good indication of who may experience the
strongest earnings recovery U.S. or foreign companies
after an earnings decline. In the early 1970s, both U.S.
and foreign earnings declined by similar amounts and
subsequently recovered by nearly equal amounts in the
ensuring recovery. In the late 1970s however, foreign
earnings bounced back much more aggressively after
underperforming U.S. profitability during the previous
recession. This happened again in the 1980s. Foreign
earnings contracted more severely and recovered more
strongly compared to U.S. results. In the 1990s, just the
opposite occurred. U.S. earnings initially declined more
dramatically and then posted a more robust recovery
compared to foreign earnings. In the early 2000s, foreign
earnings similarly declined more and recovered more
relative to U.S. earnings. In the contemporary recovery, both
U.S. and foreign earnings declined by about 45% below trend
and both initially recovered in a similar fashion. However, in
the last few years, foreign earnings have been much more
dissapointing compared to U.S. earnings.

Chart 4
S&P 500 Index vs. MSCI World Ex-U.S.A. Index
Trailing 12-month sales per share, natural log scale
Solid S&P 500 sales per share
Dotted MSCI World Ex-U.S.A. sales per share

Chart 5
S&P 500 Index vs. MSCI World Ex-U.S.A. Index
Trailing 12-month profit margin
Solid MSCI World Ex-U.S.A. profit Margin
Dotted S&P 500 profit margin

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Economic and Market Perspective | August 8, 2016

Although U.S. stocks are highly priced today, valuations

could still rise further. At about 17.5 times trendline earnings,
they are still priced lower than they were in the last recovery
and significantly below the peaks reached during the tech
bubble. However, U.S. stocks are also more expensive today
than almost any time prior to 1995 and excluding the 90s
tech run, they are near the top end of the historic valuation
range. Probably the best investors can reasonably hope for
U.S. stocks is that they maintain the current PE multiple and
simply follow earnings gains higher.

Consequently, investors should expect a more robust foreign

earnings recovery should the economic cycle soon broaden
and improve.

Chart 6
S&P 500 Index vs. MSCI World Ex-U.S. A. Index
Earnings per share as a percent above / below trendline
Solid S&P 500 EPS percent above / below trendline
Dotted MSCI World Ex-U.S.A. EPS pecent above / below trendline

Foreign stock valuations suggest a very different opportunity.

Currently, ex-U.S. stocks have a PE multiple nearly as low as
any since 1970. Moreover, the PE today is among the cheapest
of the entire recovery. Should the global economic recovery
bounce and broaden, foreign stocks should benefit both from
a superior earnings recovery and from much more valuation
improvement potential.

Chart 7
Relative stock price performance
MSCI World Ex-U.S.A. Index vs. S&P 500 Composite Index

Under-owned and a better relative value?

As shown in Chart 7, international stocks have
underperformed the U.S. stock market throughout
most of this recovery. Because foreign stocks have
underperformed so persistently, they are likely
significantly under-owned by most investors. More
importantly, they have become an increasingly good
value. As shown, on a relative price basis, ex-U.S. stocks
are lower today than at any time since at least 1970.
Charts 8 and 9 examine the current relative values of domestic
and foreign stocks based on trendline earnings. In Chart 8,
a price-earnings (PE) multiple is constructed by dividing the
price of the S&P 500 stock price index by trendline earnings
(i.e., the dotted line in Chart 2). Chart 9 calculates a similar PE
multiple for the MSCI world ex-U.S. stock index.

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Economic and Market Perspective | August 8, 2016

Chart 8

Chart 10

S&P 500 Composite Stock Price Index

U.S. Dollar Index vs. Fed funds interest rate

Price to trendline earnings (PE) multiple

Solid (left) Trade-weighted U.S. Dollar Index

Dotted (right) Fed funds target interest rate

Will U.S. dollar surprise on the downside?

Chart 9

Finally, we believe international investment returns may also

be boosted by a surprising decline in the U.S. dollar. For some
time, consensus has expected the U.S. dollar to rise. However,
despite more aggressive easing by foreign policy officials,
negative sovereign bond yields in several international
economies and less aggressive monetary policy actions in
the U.S. , the U.S. dollar has been essentially flat against most
currencies in the last year. We think the U.S. dollar has peaked
and is more likely to decline in the coming year.

MSCI World Ex-U.S.A. Stock Price Index

Price to trendline earnings (PE) multiple

Probably the biggest reason most expect a stronger U.S. dollar is

because the U.S. Federal Reserve is likely to soon begin regularly
raising the federal funds rate while foreign officials continue to
keep interest rates low. However, as shown in Chart 10, a rise
in the federal funds rate has not typically been associated with
a strong dollar as most seem to believe. The chart highlights
(by bolding) six times since 1970 when the federal funds rate
rose significantly. In every instance, the U.S. dollar index either
weakened or was essentially flat. As illustrated, both times in the
1970s when the Fed boosted the funds rate, the dollar declined.
This also occurred again during the late 1980s, the mid 1990s and
in the mid 2000s. Most recently, the U.S. dollar has also weakened
since the Fed lifted the funds rate last year.

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Economic and Market Perspective | August 8, 2016

Just because the Fed is likely to raise the funds rate in the next
year does not necessarily imply that foreign investing will be
hurt by a strong dollar. Indeed, at least since 1970, periods of
Fed tightening have more typically weakened the U.S. dollar to
the benefit of offshore investments.

has been peaking in the last year and appears likely to weaken
in the coming year. Finally, and perhaps most importantly,
compared to an aging earnings cycle in the U.S., most
international companies still have the potential to achieve
considerable earnings gains.

Summary
Most have long given up expecting any significant economic
traction from policy officials. However, for the first time in
this recovery, economic stimulus has been aligned across the
globe and evidence suggesting a synchronized economic
bounce is expanding.
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.

We suspect this change in the global recovery will benefit

foreign stock markets much more than the U.S. stock market.
For several reasons, we think investors should consider a near
maximal overweight toward both ex-U.S. developed and
emerging stock markets. International stock markets have
underperformed for some time and consequently most are
now significantly under-owned and represent better values
relative to U.S. stocks. Additionally, only the more mature
U.S. economic recovery now faces the challenges associated
with returning close to full employment. Consequently, most
international stock markets will continue to be supported by
hospitable policy actions, whereas U.S. officials are beginning
to turn hostile for the stock market. Moreover, the U.S. dollar

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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
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