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James W. Paulsen, Ph.D.

Perspective

Economic and Market


January 5, 2015

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

Some Thoughts on 2015?


Welcome to 2015! Here are a few guesses for the
new year.
Expect a good year on Main Street but a more challenging environment for Wall Street. U.S. real gross domestic
product (GDP) may rise by its strongest annual growth
rate of the recovery close to 3.5% to 4%. Current widespread anxieties about the potential for a deflationary
spiral are likely to fade as global growth outside of the
U.S. also rebounds this year. On Wall Street, good news
on the economy may become bad news for investors
as anxieties escalate over inflation/overheat/is the Fed
behind the curve fears.

last year, U.S. real GDP has averaged quarterly growth


rates of 4.4% since the summer of 2013! Economic
growth has finally moved away from the 2% stall speed
which worried so many in recent years toward a more
sustainable pace at or above 3%.
Chart 1: U.S. real GDP growth

After a pause during 2014, bond yields should resume


the process of reconnecting with the economic recovery started in 2013 when the 10-year bond yield rose
from about 1.5% to 3%. Stronger growth both here and
abroad combined with a U.S. economy now nearing
full employment should force the Fed to begin raising
the funds rate by early summer and push 10-year bond
yields above 3.5% by year-end.
The stock market is likely to experience a volatile but
essentially flattish year caught between the opposing
forces of improved economic growth and increasing evidence the Fed may be behind the curve. Similar to past
recoveries when the Fed first began tightening (1984,
1994, and 2004), expect the S&P 500 to oscillate in a
broad range between 1850 and 2250. While the stock
market may end the year a bit higher around 2150, it
may also experience a significant correction of 10% to
15% sometime during the year.
Finally, several current consensus beliefs may prove
erroneous this year and investors may be able to profit
by betting against some of these popular themes. Specifically, we expect most foreign stock markets including
the emerging markets to outpace U.S. stocks, for the U.S.
dollar to retrace some of its 2014 gains, for a revival in
commodity prices including energy prices, and for junk
and lower quality bonds to lead in a difficult bond market.

U.S. economic recovery entered a new phase


in 2014 ...
As shown by Chart 1, U.S. real GDP growth has been
between 3.5% and 5.0% in four of the last five quarters.
Indeed, excluding the weather distorted first quarter of

This newfound recovery phase is characterized not only


by faster growth, but also by a broader revival across
several aspects of the economy. The labor market is rapidly returning to health as the unemployment rate has
declined below 6% and job gains in the last year have
been the strongest of the recovery. Big ticket spending
on homes, autos, and other durable goods is noticeably
stronger, the manufacturing and services sectors both
show sustained expansions as reflected by solid ISM
readings, bank lending is finally rising at a significant pace,
record high corporate earnings continue to advance,
household net worths have risen 20% above the previous recovery cycle peak, and consumer confidence is at
its highest level in more than seven years!
Certainly, a much healthier economic recovery primarily
explains why the stock market has risen so much in the
last couple years and also why the Fed recently ended
its quantitative easing (QE) program and is nearing its
first rate hike. We anticipate real GDP growth to average
about 3% during the balance of this recovery continuing
to revive a growing sense of vibrancy on Main Street.

Economic and Market Perspective


2

... And will likely grow even faster in 2015!

Although both fiscal and monetary policies will be more


restrictive, there are several forces supporting improved real
GDP growth this year. The economy has moved away from
dependency on policy officials and is now generating its own
stimulus. We expect economic growth to be fueled primarily
by four new self-generated catalysts.
First, while many things have improved since the last recession (e.g., recapitalization of the banking industry, a purging of
bad housing debts, and a revival in business profits), the most
significant is a complete retrofit of the household sector. Since
much of the progress surrounding this sector has unfolded
only during the last 18 months, the U.S. consumer should be a
much more potent force for growth this year.
Most importantly, the job market has improved. The unemployment rate has fallen by 1.7% in the last 18 months. Job
gains in the last year have been the strongest of the recovery averaging 228K monthly. Layoffs ceased during 2014 as
unemployment claims remained below 300K for most of the
last three months. Wages also have recently shown signs of
life. Real wages have risen by about 1% since the end of 2013
to their highest level of the recovery and have surged at an
annualized pace of about 2.5% since summer.
Household balance sheets have also been restored. While
total U.S. household net worth did not recover to its previous recovery peak until the end of 2012, it has since soared
almost 20% above its previous record! The household debt
service burden has also declined to a new low from record
highs in 2007. Finally, the household debt to equity ratio
recently declined to a level comparable to where it was in the
mid-1980s.

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Gains in the household sector have also recently broadened.


Chart 2 shows real median family income. Similar to past
recoveries, it has often taken several years of recovery before
real income gains broaden to the median family. The early
1980s recession ended in August 1982, but it was not until
1984 that median incomes began rising. Similarly, the early
1990s recovery did not boost median incomes until 1994 and
the early 2000s recovery did not broaden and deepen until
almost 2006. As shown, in the current recovery, real median
family income continued to decline until 2012 and did not really begin rising until late 2013. With income gains now finally
boosting the average household, overall consumer spending
should noticeably improve.
Finally, due to all of these improvements (job market, balance
sheets, and a broadening recovery), consumer confidence
surged during 2014 to seven-year highs. We begin the new
year with a more confident and well-financed consumer than
at any time in this recovery!
Chart 2: U.S. real median family income
Thousands of U.S. dollars

Economic and Market Perspective


3

Second, the credit creation process has finally come to life.


Chart 3 shows total U.S. bank loans regularly declined until almost 2012 and rose only modestly through 2013. However, in
2014, bank lending rose at a healthy annualized pace of about
8%. Chart 4 shows lending velocity (loan volume per dollar
of the money supply) also finally recently began rising for
the first time in this recovery. Without any meaningful use of
leverage, real U.S. economic growth has averaged only slightly
more than 2% so far in this recovery. With the credit creation
process seemingly functioning again, expect economic growth
to improve and sustain at a faster pace.
Chart 3:Total U.S. bank loans*
*Adjusted for change in classification in March 2010

Third, capital spending should finally strengthen in 2015. Chart


5 illustrates the potential for improved economic growth lying
dormant on corporate balance sheets. Merger and acquisitions (M&A) have been considerable in the last couple years
as companies have added to operations by buying existing
capacity. However, since M&As have become more expensive and opportunities have become less prevalent, building
new capacity will likely become more profitable. Additionally,
the U.S. capacity utilization rate is nearing 80%, a level which
historically has initiated major capital spending cycles. Finally,
many U.S. companies have been hesitant to boost spending
plans while much of the rest of the globe is still struggling.
This year, however, capital spending could be boosted if, as we
expect, both Europe and Japan bounce and emerging world
economic growth finally bottoms.
Chart 5: U.S. corporation net cash flow as a percent of
nominal GDP

Chart 4: Loan velocity*


*Total U.S. bank loans divided by M2 money supply (log scale)

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Economic and Market Perspective


4

Lastly, as illustrated in Chart 6, a massive easing policy was


employed last year which should boost economic activity in
2015. About the globe, energy prices and bond yields collapsed! The drop in energy prices is equivalent to a major
fiscal tax cut for both businesses and consumers while the
decline in bond yields this last year is the envy of any
quantitative easing program.
Chart 6: Oil prices and U.S. bond yields

Left scaleWTI crude oil spot price (solid)


Right scale10-year Treasury bond yield (dotted)

Expect most international economies to


bounce this year?!?

Economic growth among most major international economies


is set to improve this year which should calm fears about
global deflation.
Because the eurozone initially chose fiscal austerity over the
massive monetary easing approach employed by the U.S.,
bond yields in the region rose significantly. By mid-2012, the
eurozone was widely thought to be nearing an implosion
before European Central Bank (ECB) President Mario Draghi
abruptly altered policy and finally began to lower bond yields.
This new approach worked (as it had in the U.S.) as the eurozone economy and its stock market bounced in late 2012 into
2013. However, the ECB backed away again from aggressive
stimulus and because bond yields stopped declining in 2013,
the eurozone economy failed again last year.
Most wonder whether Draghi will soon begin full quantitative easing to help reignite growth in the eurozone. However,
as shown by Chart 7, the impact of QE has already been
achieved. The goal of QE is to lower bond yields which happened last year. Since effectively QE was already successfully
employed during 2014, as evidenced by a massive decline in
regional bond yields, expect eurozone economic activity to
bounce this year.

U.S. economic growth already notched higher last year toward 3%. This year, with a stronger and retrofitted consumer,
a working credit creation process, better capital spending,
and improved results from both lower energy prices and
lower bond yields, expect real GDP growth to accelerate to
between 3.5% and 4%.

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Chart 7: Eurozone 10-year government bond yield


Median yield of 10-year government bonds for Germany, France,
Italy, Portugal, and Spain

Economic and Market Perspective


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Japan has been improved since Abenomics began expanding


the central bank balance sheet as shown in Chart 8. Although
it officially slipped back into recession last year, its stock market (Nikkei index) remains near recovery highs. Moreover, the
outlook for this year is encouraging considering the ongoing
monetary expansion implied by Chart 8, a decline by more
than one-half last year in the Japanese 10-year government
bond yield and by the considerable cheapening of the Japanese
currency. Similar to the eurozone, economic growth in Japan
may also surprise this year.

As shown by Chart 9, China is likewise stimulating its economy with lower bond yields. Its currency also experienced a
mild but rare decline last year against the U.S. dollar which
should help stimulate Chinese growth. While we do not
expect much acceleration in emerging world growth this
year, we do think the trend of slowing economic growth in
the region will end in 2015. If a consensus simply perceives
that emerging world growth has finally bottomed, it would
significantly improve the outlook for the global economy.
Chart 9: Chinese 10-year government bond yield

Chart 8: Bank of Japan monetary base reserve balances

Finally, several resource-based economies like Canada and


Australia were hampered significantly by the decline in
commodity prices last year. We expect commodity prices,
including energy prices, to have a better year in 2015, which
should help reinvigorate commodity heavy economies.

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Economic and Market Perspective


6

Deflation to reflation?

Almost 35 years of disinflation, a U.S. federal funds rate which


is still zero more than five years into an economic expansion,
unprecedented and panicky monetary policies employed
about the globe, a colossal decline in energy prices, and renewed weakness in 2014 among many global economies have
intensified fears of a deflationary spiral. However, deflation
is most likely a rear view mirror problem. Nor is inflation
destined to soon become a serious problem. While we expect
inflation to rise some this year and inflation fears may emerge
within the U.S. (based primarily on worries the Fed is behind
the curve), we think the global economy is headed for reflation (i.e., a manageable rise in the inflation rate) rather than
serious inflation or deflation.
Today, cultural mindsets are very similar (but nearly opposite)
to those which existed in the early 1980s at the end of the
great inflationary spiral. Just as inflation was enemy number
one in the early 1980s, today there is a global focus on fighting
deflation. Historically, when cultural unanimity coalesces about
a problem, it typically produces a solution. A comparison of
the eras is enlightening.
By 1980, inflation had ravaged the U.S. economy for more than
a decade. Businesses, consumers, investors, and policy officials
all anticipated rising inflation and were behaving accordingly.
Despite universal expectations for rising inflation, however,
several forces kept inflation tame. First, although demand had
been boosted for decades by the post-war baby boom generation, by the mid-1980s, aging baby boomers were weakening
domestic demand growth. Second, demand also moderated
because U.S. balance sheets were widely and substantially
damaged by the oil, farming, mining, and third world debt crises in the aftermath of the 1970s inflationary spiral. Third, the
value of the U.S. dollar doubled during the first five years of
the 1980s weakening U.S. international demands. Finally, a society obsessed with beating inflation caused monetary officials
and bond vigilantes to adopt remarkably restrictive economic
policies. Real bond yields soared and remained at crippling
levels throughout the decade, Fed chairman Volcker chomped
down on his cigar and more often than not delivered the
tough medicine that an inflation weary culture understood

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was necessary, and bond investors were quick to raise yields


to compensate for the rise in inflation they were convinced
was inevitable.
Today, after more than three decades of disinflation, chronic
deflation in the dominant technology sector, and a world
which currently hovers about the Mendoza line near zero
inflation, most are increasingly obsessed with the potential for
a deflationary spiral. Despite universal expectations of falling
inflation/deflation, however, several forces are emerging which
likely ensure serious deflation will not result. First, while global
demand is being curtailed by aging demographics in the developed world, it is also in the early stages of being boosted by
newfound demand growth from emerging world economies.
In the last decade, emerging economies were primarily a supply story adding to disinflationary forces. However, emerging
economies are rapidly transitioning toward a major demand
story which will probably prove much larger than the postwar baby boom. Second, balance sheets within the U.S. have
been significantly retrofitted since the 2008 crisis. Banks have
perhaps never been as strongly capitalized as they are today
and have unprecedented lending capacity. Corporate profits
are at record highs, business balance sheets are strong, and
cash flows are immense. U.S. household net worth is almost
20% higher than its previous record and the debt service
burden is at a new low. Household and corporate pent-up demands are considerable (due to the pause in spending during
the crises of the 2000s) and the credit creation process is just
beginning to revive. Third, as shown in Chart 10, despite the
recent rise in the U.S. dollar, the broad real U.S. dollar index
still remains at a very low level! Therefore, a competitively
priced U.S. economy should entice a growing share of global
demands. Finally, a cultural obsession with depression and
deflation evident since the 2008 crisis has produced unprecedented and massive economic policy stimulus despite a
continuous economic recovery in the U.S. for more than five
years. The never before employed quantitative easing has ballooned the Feds balance sheet, the federal funds interest rate
remains near zero and almost 2% below core inflation, and
the 10-year bond yield is only about 2.1% despite real GDP
growth between 3.5% to 5% in four of the last five quarters!

Economic and Market Perspective


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Chart 10: Real trade-weighted U.S. dollar index

Chart 11: S&P GSCI Spot Commodity Price Index

When a culture becomes universally obsessed with a problem,


it generally solves it! Arguably, U.S. policy officials have never
employed as aggressively stimulative and unprecedented monetary policies as it has in this recovery (because the cultural
obsession surrounding deflation risk has never been this pronounced?). But the obsession does not stop at U.S. borders.
Who could conceive that the ultra-conservative culture of
Japan would ever adopt Abenomics? Or perhaps even more
shocking is the epicenter of historical inflation hypochondria,
Germany, where President Angela Merkel quietly stands down
as ECB President Draghi nears full-bore quantitative easing!

Chart 12: S&P GSCI Non-energy Spot Commodity


Price Index

Rising inflation in 2015?

Perhaps a strong case for deflation can be made by looking


through the rear view mirror, but it appears much less convincing when peering out the windshield. Prepare for reflation
in the next several years beginning with a mild rise in core
consumer price and wage inflation in the U.S. this year.
While deflation fears have persisted since the 2008 crisis,
they intensified last year primarily because commodity prices
collapsed. However, as shown by Charts 11 and 12, rather
than reflecting a broad based deflationary spiral, last years
decline in commodity prices was mainly a one-off energy
story (perhaps growing U.S. energy independence?). The S&P
GSCI non-energy commodity price index did not collapse
last year. Indeed, it was essentially flat in 2014 and has actually
risen some since September when the decline in energy
prices was most pronounced.

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With the unemployment rate on a trajectory to fall below


5% this year, rising wage inflation is likely to become more
obvious. This could force quite an adjustment in the financial
markets comprised by a majority of investors who perhaps
misinterpreted an oil price decline as evidence of broadening
deflation. What happens when the deflationary culture of
2014 meets rising inflation indicators in 2015? How will the
bond market react? Junk bond yield spreads? Stock Prices?
Commodity prices? Material stocks? The Fed?

Economic and Market Perspective


8

Bet against the U.S. dollar in 2015!

Most expect the U.S. dollar to continue rising this year. The
Fed will likely begin raising interest rates soon while sluggish
growth abroad should keep policy officials there in accommodation mode. However, it is not the different monetary policy
actions which matter most for the currency. Rather, it is how
those actions are perceived. If the more aggressive policies in
the eurozone and Japan work and boost economic growth, it
should bring a bid to both the euro and the yen. Conversely,
if the Fed begins raising interest rates but only after most investors believe they are behind the curve, worsening inflation
anxieties would reduce the value of the U.S. dollar. We expect
the pace of economic growth to improve across the globe
this year. In many weaker international economies, this will be
met with relief and a partial revival in currency values which
were widely priced for recessions or worse. However, since
the U.S. is nearing full employment while growing at one of its
strongest paces of the recovery, good news on Main Street
may become bad news on Wall Street. That is, if inflation/
overheat/Fed behind the curve fears escalate, the U.S. dollar is
likely to retrace some of its recent gains.
Moreover, as illustrated in Chart 13, developed world currencies have remained in a broad range for several years. For
example, the euro/dollar exchange rate has remained largely
within a range between about 1.2 to 1.45 for the last decade.
Developed economies all suffer from a similar fateaging
demographics which have slowed potential economic growth.
Because economic growth is so scarce, no developed country
is allowing another to steal precious growth through cheap
devaluations. In our view, competition for growth among
developed economies has caused exchange rates to be unofficially tied together within broad trading ranges. Currently, the
U.S. dollar is near the upper end of these multi-year trading
ranges against most developed country currencies including
both Japan and the eurozone. As shown in Chart 13, if the
widely feared imminent breakup of the eurozone union in
2012 could not force the euro-dollar exchange rate out of
its prolonged trading range, we doubt it will fall much lower
against the dollar today.

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Chart 13: Euro/U.S. dollar spot currency rate

Bond yields working back toward


equilibrium?

U.S. government bond yields have mostly been established by


fear during this recovery. While bond yields in 2013 began
to move back toward equilibrium levels which more closely
reflect a growing economy, this process stalled and partially
reversed last year. We expect bond yields to eventually trend
higher this year and to resume the process of reconnecting to
the economic cycle.
Historically, the 10-year bond yield (Chart 14) has ranged
between 2% to 4% above the annual rate of core consumer inflation when in equilibrium with the economic cycle. Since the
2008 crisis, bond yields have remained below equilibrium being
dominated by fear rather than fundamentals. However, consumer confidence recently rose to a seven-year high and bond
yields have begun the process of reconnecting to the economy.
Annual core consumer price inflation is currently 1.7% and
we expect it to rise above 2% this year. Consequently, this
valuation model suggests a 10-year bond yield of about 4% (i.e.,
reaching the lower dotted line in Chart 14) would represent a
yield in rough equilibrium with the economic recovery.

Economic and Market Perspective


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Chart 14: Real 10-year Treasury bond yield*


*10-year bond yield less core CPI inflation rate

Chart 15: 10-year Treasury bond yield

Since we expect another 1% decline in the unemployment


rate this year (dropping it below 5%), a rise in both core
consumer price and wage inflation, and about 3.5% to 4%
real GDP growth, we suspect bond investors and the Fed
will come to perceive the current interest rate structure as
woefully low. After a year which handsomely rewarded bond
investors, we think bond market risk will return this year. Our
best guess is the 10-year bond yield ends the year between
3.5% and 4%. While this forecast calls for a large (perhaps
unrealistic?)upward move in yields, Chart 15 is a good reminder that bond yields can move quickly and aggressively. In
late 2010, the 10-year bond yield surged by 115 basis points
in two months. And in 2013, it increased by about 150 basis
points in three months!

Chart 16: U.S. 10-year Treasury bond yield


Natural log scale

Finally, investors should be aware of an important technical


yield level which may be achieved in 2015. Chart 16 shows
the 10-year Treasury bond yield on a natural log scale. Since
the early 1980s, bond yields have established a series of
lower highs and lower lows technically reinforcing an
ongoing bull market in bonds. As illustrated, should the
10-year bond yield reach close to 4% this year, it will establish
the first higher high bond yield in more than three decades! If
this does transpire, it would most likely cause a major shift in
investor sentiment since it would be perceived as the end of
the Greatest Bond Bull in U.S. history!

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Economic and Market Perspective


10

StocksVolatile and flattish year?

The stock market is likely to reflect a conflict between two


opposing forces resulting in a volatile but largely flattish year.
The economy has clearly shifted to a higher gear and if real
GDP growth can persist above a 3% rate without aggravating
inflation or interest-rate pressures, the stock market could
melt up! Indeed, the speed and power of market rallies since
last summer exhibit that late 1990s feel of growth without
inflationary consequence! Unfortunately, however, with
the unemployment rate now below 6% and declining about
1% annually, continued strong economic growth will likely
soon awaken inflationary concerns. For stock investors, solid
growth this year is therefore likely to struggle with rising inflation anxieties and concerns about whether and by how much
the Fed may be behind the curve.
The challenge for the stock market is not higher interest rates
per se. Clearly, interest rates are extremely low by historical
standards and would still be low even if they rose some in
2015. Indeed, the stock market recently established it could
rise despite an aggressive increase in bond yields. Between
April and December of 2013, while the 10-year Treasury bond
yield increased from about 1.5% to about 3%, the S&P 500
soared from about 1500 to about 1850! The concern for the
stock market is not whether yields rise, but rather the reason yields rise. In 2013, yields rose primarily because most
investors finally gave up the Armageddon ghost and decided
the economic recovery was no longer in imminent danger of
ending. Bond yields priced for the end of the world needed
to be realigned for a slow but sustained recovery. A major
mindset change deciding the world wasnt about to end
boosted both bond yields and stock prices.
In early 2013, when investors began to realize economic
growth was broadening and improving, the unemployment
rate was still near 8%. Because of ample slack in the labor
market, the economy could grow without inflationary consequence. Today, by contrast, the fastest growth of this recovery
will likely drop the unemployment rate below 5% before the
year has ended raising inflationary concerns. If bond yields are
pushed higher, not because economic growth has improved,
but rather to compensate bond investors for higher expected
inflation, this will be a much more daunting challenge for the
stock market.

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In addition to the potential conflict this year between improved economic growth and potential inflation fears, the
stock market also shows three significant vulnerabilities.
First, as illustrated in Chart 17, investor sentiment is currently calmer and more confident about the future than it has
probably been at any point in this recovery. The foundation of
the current bull market since the great 2008 crisis has been
climbing a perpetual wall of worry. The common characteristic of this recoveryfearseems to be absent as we
begin 2015. Three years of solid gains in the stock market and
much better conditions on Main Street have dulled investor
appreciation for risks. Often the stock market delivers a nasty
reminder about risk just when most investors start to believe
the water looks safe again.
Chart 17: AAII U.S. Investor Sentiment Index
Percent bulls less percent bears

Economic and Market Perspective


11

Second, as shown in Chart 18, the stock market is no longer


cheap. The trailing price/earnings (P/E) multiple has risen by
about 45% in the last three years and at about 18 times, the
P/E is now significantly above average by historical norms.
Although the P/E multiple is far from all-time record highs, it
is more extended than at any time in this recovery. Moreover,
P/E multiples also likely face two of their biggest historical
antagonists. The Fed seems poised to begin raising interest
rates and inflation anxieties are likely to worsen this year.

Chart 19: U.S. federal funds interest rate

Chart 18: S&P 500 trailing price/earnings multiple*


*Based on trailing 12-month earnings per share

Chart 20: S&P 500 price/earnings multiple versus federal


funds interest rate
Left scaleP/E, natural log scale (solid)
Right scaleFederal funds rate, inverted scale (dotted)

Finally, Chart 19 reminds investors a watershed event is


nearing. The Fed has never taken this long during a recovery
to begin raising interest rates and they will likely finally start
the process before the year is over. Chart 20 shows P/E multiples almost always decline when the Fed begins increasing
the funds rate. Although the stock market does not typically collapse when the Fed initiates rate hikes, it has usually
struggled. Consider the flattish stock markets (and most
produced a correction) of 1983-1984, 1994, and 2004 when
the Fed first began to raise the funds rate. Finally, after the
most unprecedented, unconventional and massive monetary
easing cycle in post-war history, it seems unrealistic the Fed
can finally reverse course without any notable consequence
for the stock market.

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Economic and Market Perspective


12

Our guess is these conflicting forces will resolve in a volatile


but essentially flattish stock market in 2015. The fact U.S.
economic growth has finally broadened and appears to be
sustaining above a 3% rate is extremely good news. If this pace
and character of growth can be maintained without any notable inflation or interest-rate consequence, the stock market
could well melt up la 1990s style! Indeed, because investors
may occasionally feel like we are replaying the non-inflationary 1990s, the upper end of our trading range for the S&P
500 is 2250. Most likely, however, solid economic growth this
year will aggravate inflation concerns causing stock investors
to worry over higher bond yields and Fed activities. If these
concerns flare during the year, the S&P 500 could also revisit
the 1850 area. Overall, while the S&P 500 may end the year a
bit higher (we picked 2150 with little conviction), we expect it
to be interrupted by a couple nasty gut checks and perhaps an
official correction along the way.

The BULL is probably not over!

We think the U.S. may be in the middle of the longest economic recovery in its history. If this is accurate, notwithstanding perhaps a more difficult 2015, the current bull market
probably is far from over.
The U.S. economic recovery is five and one-half years old and
is already longer than a normal recovery. However, for two
primary reasons, we expect it will last several more years.
First, during the last three decades, recoveries have lengthened compared to historic norms. The U.S. experienced an
eight-year recovery in the 1980s, a 10-year recovery in the
1990s, and a six-year recovery in the 2000s. Aging U.S. demographics caused the growth rate in the working age population to slow nearly by one-half since 1985. Since the labor
supply has grown far slower, the overall pace of U.S. economic
growth has also been noticeably weaker. The silver lining of
slower growing recoveries, however, is they tend to persist.
It takes longer to tighten resource markets, create inflation
or interest rate pressures, and produce the excessive private
sector behaviors which ultimately make the economy vulnerable again to a recession. While the contemporary recovery is
in its sixth year, it is younger than the average recovery during
the last 30 years!
Second, recessions often result from overconfidence among
private sector players, investors, and policy officials. Typically
in recoveries, confidence eventually mutates toward cockiness. Businesses over-expand, consumers over-leverage, banks
over-lend and the Fed over-tightens. These are precisely the
behaviors which bring the next recession. Today, due to the
severe psychological damage done by the great 2008 crisis,

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although confidence is improving, we still have an economy


being run by a bunch of church mice which are focused on
practicing prudent economic and investment behaviors. Are
firms overbuilding or over-staffed? Are consumers borrowing
too much? Are investors overexposed to the stock market?
Has the Fed over-tightened? By the end of this recovery, we
expect economic cockiness and excessive behaviors to be
much more obvious eventually requiring another recession.
But, at this point, the recovery seems solid and behaviors still
too conservative to raise recession risk. And, if it takes several
more years before behaviors become excessive again, the
stock market will likely be much higher before it is over.
The S&P 500 Stock Price Index has risen by more than 2.5
times from its low in early 2009. Despite this amazing rally,
however, it has only returned to average by post-war standards! Chart 21 illustrates the U.S. stock market compared
to its trendline average. During the last 70 years, U.S. stocks
have risen about 7% annually (i.e., the slope of the trendline
in the chart calculated by a regression of the log of the stock
market against time). Actually, the stock market has oscillated
about its long-term trend, sometimes significantly below (e.g.,
1950,1974, or 2009) and other times far above (e.g., 1957,
1966, 1972, and 2000). Today, the stock market is neither
extremely cheap nor excessively expensive. Rather, it sits atop
its trendline or is simply average.
Chart 21: S&P 500 Stock Price Index versus trendline
average

Economic and Market Perspective


13

There have been only two other times in post-war history when the stock market finally reached trendline again
after languishing far below average for several years. The
1950s-1960s bull market reached trendline in the mid-1950s
and the 1980s-1990s bull market reached trendline in the
early 1990s. Both of these previous bull markets rose nearly
as much after reaching trendline than they did recovering to
trendline. Consequently, since todays stock market seems
similarly positioned (i.e., it has just returned to average), provided the economic recovery is not prematurely aborted by a
near-term recession, this bull market could last considerably
longer and rise significantly more.
A little math illustrates the potential for stocks should the
current economic recovery last several more years. Trailing
earnings per share for the S&P 500 should be close to $120
as of year-end 2014. Assume the economic recovery continues for another five years and earnings grow only modestly at
about 4% annually. Perhaps annual nominal GDP growth is 5%
to 6% so this assumes some profit margin erosion. However, this would put trailing 12-month share earnings at about
$145 for the S&P 500 in five years. If the P/E multiple reaches
previous post-war bull market peaks in the low 20 times
earnings, the overall S&P 500 could surpass the 3000 level!
With dividends, this would represent about 10% buy and hold
annual returns during the next five years.
As this example shows, although 2015 may prove more
challenging for the stock market, investors should not get
too defensive since its long-term potential remains favorable.
Nobody will remember if you avoided a 10% to 15% correction in 2015 if you are incorrectly positioned for the next
50% advance!

2015 investment recommendations


Here are a few portfolio thoughts for 2015.

First, despite a potentially flat stock market this year, keep


portfolios near a maximal overweight toward stocks. The longer term potential for equities remains too favorable to gamble heavily on a risky market timing bet. Moreover, alternative
asset classes mostly remain unattractive. Bonds have considerable downside risk this year and cash offers a zero return.

WELLS CAPITAL MANAGEMENT

Second, consider allocating a small part of the maximum


overweight in equities toward commodities. We think the
decline in commodity prices last year was overdone and this
market represents a good value for 2015. We also expect a
weaker U.S. dollar this year to help boost domestic commodity prices. Finally, economic growth about the globe should
surprise this year creating a much better backdrop for the
commodity market.
Third, approach fixed-income investments conservatively.
Continued solid U.S. economic growth, worsening reports
on both wage and consumer price inflation, and escalating
anxieties surrounding whether the Fed has fallen behind the
curve should push the 10-year yield above 3.5% this year.
Duration should remain below average and bond portfolios
should emphasize lower quality exposures. Indeed, because
junk yield spreads widened significantly last year, they now
represent a good relative value. We also would begin the year
positioned for a steeper yield curve. In our view, before the
Fed begins raising interest rates (and flattening the curve),
bond vigilantes will increase the 10-year bond yield above 3%.
Be prepared, however, to move positioning toward a barbell
once the Fed begins to lift rates. Finally, although we expect
sovereign bond yields to rise about the globe this year, they
are likely to increase less outside the U.S.
Fourth, bet against the deflation spiral story which became
so prevalent in 2014. Fear of deflation impacted the pricing
of several assets which may reverse in 2015. The U.S. dollar
strengthened last year primarily because economic growth
improved domestically while it mostly weakened elsewhere.
World investors flocked to the U.S. as the last bastion in a
globe headed toward a deflationary abyss. Expect a bounce in
most global economies which closes the gap to U.S. economic growth and reduces the safe-haven value embedded in
the U.S. dollar. Bet on global reflation for 2015. Significantly
overweight equity outside of the U.S. Allocate toward the
stock markets of beat-up commodity-based economies (e.g.,
Canada and Australia), examine some higher yield junk bonds,
establish a position in a commodity exchange traded note,
and overweight the energy and materials sectors in equity
portfolios. The world is not likely headed anytime soon for
runaway inflation, but nor is it likely to succumb to a deflationary spiral.

Economic and Market Perspective


14

Fifth, move portfolio exposure away from policy officials


turning less supportive (U.S.) toward officials which are likely
to remain accommodative in 2015 (eurozone and Japan).
Both of these stock markets have cheapened considerably
relative to the U.S. stock market and if the U.S. dollar
reverses this year, the dollar-based returns from offshore
investments could be boosted even further.
Sixth, although emerging stock markets have been
underperforming since early in this recovery, we would still
recommend an overweighted position. Most emerging market
policy officials are now attempting to improve economic
growth. We expect they will at least be successful in stopping
the erosion in emerging economic growth. Ultimately, we
think the emerging world will be able to sustain about a 6%
annual growth rate in the next several years. Conversely, due
to aging demographics, the U.S. will probably only be able to
deliver about 3% sustained growth. Currently, the emerging
world stock market can be purchased for about 12 times
earnings compared to about 18 times in the U.S.
Seventh, increase exposure to small-cap stocks. Historically,
small caps have outpaced large caps when the rate of

WELLS CAPITAL MANAGEMENT

inflation accelerates. The escalation of deflationary fears


has been particularly troublesome for smaller companies.
Large companies often run with fluff and can consequently
adjust more easily to weak top-line pricing results. Smaller
companies, by contrast, typically run much leaner and
therefore do not have much room to cut excess when topline pricing fails. However, because small companies run lean,
they also have much stronger operating leverage should
top-line results improve. If deflation fears are replaced this
year by a modest rise in inflation, small-cap stocks should be
market leaders.
Finally, in the U.S. stock market, overweight the energy,
materials, and staples sectors. Both energy and materials
stocks offer good current values and reflation tends to
benefit all three of these sectors. We would underweight
consumer discretionary stocks (typically they do not do
well when the inflation rate rises or when the Fed tightens),
health care stocks (simply overvalued and extended), and
utilities (may suffer with higher bond yields). Finally, we
are neutral on technology (will benefit from better capital
spending but is typically high beta in a volatile market),
industrials, and financials.

Economic and Market Perspective


15

Summary

Even if the stock market does indeed prove flattish this year,
the financial markets could still have a very successful year
in refreshing the bull market. If earnings rise again this year
while the stock market trends sideways, the P/E multiple may
be back closer to average again as we enter 2016. Moreover,
by year-end, interest rates may be at more appropriate levels
which would reduce future inflationary concerns and improve
the longevity of the recovery. Furthermore, if the stock market does suffer a correction this year, investor sentiment may
again be much more conducive to an ongoing bull market (i.e.,
appropriately conservative with ample buying power on re-

WELLS CAPITAL MANAGEMENT

serve outside of the stock market). Finally, because of current


efforts about the globe to revive growth, a year from now the
emerging world, eurozone, and Japanese economies may look
much healthier and sustainable.
Although 2015 may prove a more difficult environment for
capital gains, it may be very beneficial in setting up the second
half of this recovery. If a flat stock market and higher yields
refreshes valuation, improves sentiment, and gets the Fed to
finally reconnect interest rates to this economic recovery,
then it may be a very successful year indeed?

Economic and Market Perspective


16

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 Management and its advisory services, please view our web site at www.wellscap.com, or
refer to our Form ADV Part II, which is available upon request by calling 415.396.8000. WELLS CAPITAL MANAGEMENT is a registered service mark
of Wells Capital Management, Inc.
Written by James W. Paulsen, Ph.D. 612.667.5489 | For distribution changes call 415.222.1706 | www.wellscap.com | 2015 Wells Capital Management

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