James W. Paulsen, Ph.D.

Perspective

Economic and Market

February 24, 2015

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

The KL Ratio is Rising ... But Will Productivity Follow?

After languishing in a sideways range for almost 15 years
in the aftermath of the late 1990s tech bubble, a proxy
for the U.S. capital to labor ratio (KL) recently rose to
a new all-time record high. Throughout postwar history,
changes in the KL ratio have been closely associated with
the relative total return performance of stocks compared to bonds. Indeed, since the U.S. KL ratio flatlined
after the internet bubble, the stock market has experienced its largest and longest postwar era of underperformance relative to U.S. bonds.
The U.S. KL ratio appears to be in the early stages of
another significant advance. U.S. corporations have
considerable cash reserves and pent-up demands to
drive a capital spending cycle while the supply of labor
is increasingly being restrained by aging demographics.
If the KL ratio does continue to rise, stock returns
should persistently outpace bond returns. The question is whether this will be mainly due to good returns
from the stock market or bad returns from bonds? The
answer will likely depend on the performance of U.S.
productivity during the balance of this recovery.

The KL ratio and the stock-bond ratio

Exhibit 1 overlays the relative total return performance

of U.S. stocks compared to long-term U.S. government
bonds since 1950 with the U.S. KL ratio. The KL ratio
is estimated by a ratio of U.S. industrial capacity and
the U.S. labor force. Whenever the U.S. labor supply
enjoys additional industrial capacity (i.e., more capital),
equity owners tend to benefit relative to debt owners.
Most likely, this is because when labor is given more
capital, it boosts productivity and augments corporate
earnings potential.

The stock market has enjoyed two golden eras since

1950 (between 1950 and 1970 and again during the
late 1990s) when returns solidly outpaced bonds and
both were associated with a persistently rising KL ratio.
Conversely, both periods when stocks either underperformed or only managed to match debt returns (i.e.,
1970 to 1995 and again since 2000) were when the KL
ratio faltered. The current bull market began in March
2009 and the KL ratio has been rising since the beginning of 2010. The KL ratio just reached an all-time record high. Does this suggest the relative performance of
stocks will likely surpass its previous record high before
the current recovery ends?
Exhibit 1: Relative stock-bond return performance versus
capital-labor ratio*
Left scaleRelative total returns, U.S. large-cap stocks versus longterm U.S. government bonds (solid)**
Right scaleTotal U.S. capacity index divided by U.S. labor force
(dotted)***
*Both series shown on a natural log scale
**Source: Ibbotson and Bloomberg
***Capacity index is U.S. manufacturing index until 1967 and total
industry thereafter

Economic and Market Perspective

2

Capital growth spurts while labor growth

fizzles

Exhibit 2 separates the components of the KL ratio. The annual growth in capital has recently spurted to its strongest pace
since the early 2000s whereas labor force growth continues
to hover about postwar low growth rates. Indeed, the relative
growth in both capital and labor during this recovery appear
similar to the two previous periods in postwar history when
the KL ratio spurted (in the 1960s and 1990s).
In our view, the KL ratio is likely headed for its third major
advance since WWII suggesting the spread between stock and
bond returns should widen considerably in the next several
years. It has been 15 years since the last major capital spending cycle and pent-up demands must be considerable. Moreover, corporate balance sheets are healthy and they possess
abnormally large cash reserves which could be used to drive
a prolonged capital spending cycle. Conversely, aging U.S. demographics ensure a continued paltry growth rate in the U.S.
labor supply. Combined, it appears increasingly likely the U.S.
KL ratio is headed for a sustained period of advance probably
helping to eventually push the relative performance of stocks
relative to bonds to a new all-time record high.
Exhibit 2: Annual U.S. capacity growth versus annual U.S.
labor force growth
Capacity growth (solid)
Labor force growth (dotted)

A better stock market, a bad bond market,

or both?

If a rising KL ratio in the next several years results in stocks

continuing to outpace bonds, will it be primarily because
stocks do well, bonds do poorly, or both? Exhibit 1 sheds little
light on this question. For example, the KL ratio rose from
1950 to 1970 and although stocks soundly outpaced bonds
throughout, stocks and bonds experienced varied performances. In the 1950s, stocks consistently outpaced bonds
both because stocks did well and because bonds did poorly.
Between 1960 and 1965, stocks did well while bonds provided
coupon returns and during the last half of the 1960s neither
asset class did well. Likewise, while the KL ratio trended
sideways in the 1970s and 1980s, both stocks and bonds did
poorly in the 1970s and both did well in the 1980s.
If the KL ratio does continue to advance in the next several
years, whether stocks do well or bonds simply do poorly may
depend on how U.S. productivity performs. Exhibit 3 shows
the U.S. productivity index as a percent of its postwar trendline average. When this series rises, U.S. productivity grows
faster than its long-term average.
From Exhibit 1, there have been two major periods when
stocks sharply and consistently outpaced bonds since 1950
between 1950 and 1970 and again between 1995 and 2000.
It is instructive to examine what productivity did during
these two stock eras. Between 1950 and 1965, productivity
persistently rose faster than average, and as shown in Exhibit
1, stocks not only chronically outpaced bonds but produced
solid absolute returns. Similarly, between 1995 and early 2000,
productivity rose at above average rates and stocks not only
outpaced the bond market but provided handsome standalone returns for investors.
There has been only one time since 1950 when the KL ratio
rose and stocks did not provide good returns. Between
1965 and 1970! In this period, although stocks continued to
outpace the bond market, the U.S. stock market was essentially flat and consequently provided investors only modest
dividend returns. Why was this the only time in postwar
history when a rising KL ratio did not handsomely reward
stock investors? Because, as shown in Exhibit 3, U.S. productivity was subpar. In 1965, U.S. productivity growth slowed
and although stocks still outpaced bonds (since the KL ratio
kept rising until 1970), they no longer provided investors
significant performance.

WELLS CAPITAL MANAGEMENT

Economic and Market Perspective

3

Will productivity soon accelerate?

As Exhibit 3 shows, U.S. productivity growth has been below

average since 2010. While a rising KL ratio bodes well for
stocks continuing to outpace bonds in the next few years,
for stocks to provide investors with solid returns, productivity probably needs to soon accelerate. Historically, a rising
KL ratio (i.e., providing more capital per unit of labor) has
led to faster productivity growth. So far, the contemporary
recovery has been without superior gains in productivity.
Consequently, U.S. productivity may now represent both the
primary risk (i.e., if it fails to improve) and hope (i.e., could an
la 1950s-1960s or late 1990s productivity style stock market
run still lie ahead?) for stock investors.
Exhibit 3: U.S. productivity index as a percent of trendline
average

WELLS CAPITAL MANAGEMENT

Summary???

Stock investors should be pleased the U.S. KL ratio has finally

reached all-time record highs and that it appears likely to
continue rising (both because a capital spending cycle seems
to be emerging and because the U.S. labor supply will remain
limited). This implies stocks should continue to outpace bond
returns in the next few years. Moreover, historically, the stock
market has usually provided solid stand-alone returns when
the KL ratio was rising. The notable exception was when
productivity failed to improve. U.S. productivity has been disappointing since early in this economic recovery and its future
performance probably represents the biggest risk and hope
for stock investors during the rest of this recovery.

Economic and Market Perspective

4

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