Wells Capital Management

Perspective

Economic and Market

September 17, 2015

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

A Leadership Change?
Chart 1
James W. Paulsen, Ph.D
Chief Investment Strategist,
Wells Capital Management, Inc.

Most investors are understandably focused on whether the

Federal Reserve will raise interest rates today and what this
may imply for the recent stock market correction. However,
underlying recent financial market volatility and this Fed drama
is perhaps marking a major change in stock market leadership.
We believe commodity prices are in the process of bottoming
after trending lower during the last four years of this recovery.
The current stock market correction and the first Fed hike in
interest rates may be marking an important shift in economic
pricing power from consumer prices to lower stage industrial
prices. A shift in economic pricing power from consumers to
producers has traditionally altered stock market leadership
away from domestic toward international stocks and from
consumer to industrial stocks.

Are commodity prices bottoming?

As we examined in an earlier research note (see the Economic
and Market Perspective from August 25, 2015), a significant
collapse in commodity prices during the middle of an
economic recovery is actually quite common. Chart 1 shows
the S&P GSCI Spot Commodity Price Index since 1970. The
collapse in commodity prices since last summer is similar to
past recoveries and like then, it does not suggest economic
growth is about to slow.

S&P GSCI Spot Commodity Price Index

Natural log scale

Economic and Market Perspective | September 17, 2015

Chart 2

In three of the last four recoveries (i.e., the late-1970s, 1980s

and 1990s recoveries), commodity prices suffered a severe
decline during an ongoing economic recovery. In each of
these cases, the economic recovery persisted well beyond
the bottom in commodity prices. Indeed, in the past, once
commodity prices bottomed, the pace of economic growth
accelerated and the recovery did not end until commodity
prices had substantially recovered. For example, in the late1970s recovery, commodity prices bottomed in July 1977
and the recovery did not end until January 1980. Similarly,
commodity prices bottomed in July 1986 but the economic
recovery continued until July 1990. Finally, commodity prices
bottomed in early 1999 but the recovery did not peak until
March 2001. As shown, a significant decline in commodity
prices usually points to stronger rather than weaker future
economic growth. Moreover, once commodity prices do
finally bottom, they have typically risen throughout the
balance of the economic recovery.

WTI crude oil spot price

Although most believe oil prices (and overall commodity

prices) are continuing to collapse, chart 2 suggest they have
been in a bottoming process since early this year. While the
spot price of WTI crude oil did collapse last year, it is currently
about $45, a level it first reached in mid-January. We suspect
the commodity markets are about to embark on a multi-year
advance which will likely alter leadership in the economy and
in the stock market.

Chart 3
Core consumer prices vs. core crude producer prices
Natural log scale

Economic pricing power

Stock market leadership is often concentrated among
companies possessing economic pricing power. Chart 3
examines the pricing power between two major segments
of the U.S. economy the consumer and the producer. The
core crude producer price index tends to move similarly with
overall broad-based commodity prices. Similar to the S&P GSCI
commodity price index, the core crude producer price index
has declined since the summer of 2011 and suffered a major
collapse during the second half of last year. Not surprisingly,
core crude producer prices are much more volatile compared
to consumer prices. Consequently, economic pricing power
tends to shift between producers and consumers as commodity
prices rise and fall.

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Solid: Core Consumer Price Index

Dotted: Core Crude Producer Price Index
(crude non food materials less energy)

Economic and Market Perspective | September 17, 2015

Consumer companies have enjoyed strong relative product

pricing since 2011 (primarily because producer pricing has
been so weak) but this prolonged trend may soon change if
low stage producer prices are bottoming. If economic pricing
power does change, investors should also anticipate that stock
market leadership might experience a transformation.

Chart 4
U.S. / ex-U.S. total return stock performance vs. CPI/PPI
Ratio
Dotted (right natural log scale): Ratio of Core Consumer Price Index
divided by Core PPI Index for crude non food materials less energy
Solid (left natural log scale): MSCI relative total stock market retrun :
U.S. stock market vs. global ex-U.S. stock market in U.S. dollars

New stock market leadership?

Charts 4 and 5 illustrate two major stock market trends likely
to undergo leadership changes should commodity prices soon
bottom.
The dotted line in both charts represents the economic pricing
power of consumer companies relative to producer companies.
It is a ratio of the core consumer price index relative to the
core crude producer price index. Chart 4 compares economic
pricing power (dotted line) with the total return performance
of the U.S. stock market relative to international stocks (solid
line). While not a perfect relationship, changes in economic
pricing power have been highly correlated with the relative
performance of domestic versus international stock market
returns. U.S. stocks tend to outpace foreign stocks when
consumer pricing power dominates producer prices. Most
likely, this is because the U.S. economy is more consumer
centric compared to foreign economies. By contrast,
international stock returns typically outpace U.S. returns during
periods of relatively strong producer pricing trends. As shown,
consumer prices have been outpacing producer prices for most
of the last four years and U.S. stocks have dominated global
returns during this time. However, if commodity prices soon
begin to rise again, stock investors may want to increase foreign
market allocations.

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Economic and Market Perspective | September 17, 2015

Chart 5

Summary
The current Fed drama may be signaling more than simply
a stock market correction. We believe commodity prices are
nearing a bottom and expect that economic pricing power will
soon switch from consumer to industrial companies for the
balance of this recovery. Consequently, stock investors should
consider boosting allocations toward industrial and producer
stock sectors and reducing exposure to the U.S. stock market in
favor of foreign equities.

Consumer / industrial total return stock performance vs.

CPI/PPI Ratio
Dotted (right natural log scale): Ratio of Core Consumer Price Index
divided by Core PPI Index for crude non foodmaterials less energy
Solid (left natural log scale): Relative total return performance of
consumer sectors vs. industrial sectors. Data from Kenneth French
12 sector U.S. universe. Consumer sectors include consumer non
durables, consumer durables, telecom, utilities and shops (retails).
Industrial sectors include manufacturing, energy and chemicals.
Sectors are equal weighted.

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.

Chart 5 illustrates an even closer historic relationship between

consumer/producer relative economic pricing power and
the relative total return performance between consumer and
industrial stock sectors. So far in this recovery, economic
pricing has persistently favored consumer companies and
most consumer stock sectors (e.g., the S&P 500 consumer
discretionary sector). Nonetheless, should commodity prices
soon bottom; stock market leadership in the balance of this
recovery may be concentrated among the industrial stock
sectors.

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