Wells Capital Management

Perspective

Economic and Market

December 15, 2015

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

Stock Market Capacity Utilization Rate

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

How much potential is left in the current bull market? After all,
the stock market is in its seventh year of recovery and has risen
more than three-fold from its low in March 2009.
The ultimate capacity of any bull market is of course a
complicated calculation dependent on an unspecified and
not readily accepted set of factors. For example, how much
room is left for improvement in investor sentiment? Are most
investors already fully invested in stocks or are they sitting on
considerable cash balances? Are valuations reasonable or are
they nearing historic highs? How competitive are alternative
investment returns? Do policy officials still have room to
implement supportive accommodative policies? How young
is the corporate earnings cycle? Are company balance sheets
strong? Does the economy still have room for improvement or
are late cycle cost-push pressures evident?
Capacity utilization is a concept long used when judging the
economic cycle. Concepts like the factory utilization rate, the
labor unemployment rate and the economys output gap
help in accessing the age of an economic recovery. In a similar
fashion, this note calculates and examines a capacity utilization
rate for the U.S. stock market. While no single indicator is ever
definitive, based on its utilization rate, the contemporary bull
market is no spring chicken.

Estimating the utilization rate

Although there is no conventional measure of a stock market
utilization rate, we use four major factors to capture the multidimensional character of stock market capacity.

First, the valuation level of the stock market is defined by

the trailing 12-month price-earnings (P/E) multiple. The P/E
multiple has remained range-bound in the post-war era
mostly oscillating between about 7 and 21 times earnings.
While high valuations do not necessarily end a bull market,
they do diminish its potential since once P/E multiples reach
historic limits, the stock market at best can only rise at the
pace of earnings growth.
Second, the 10-year Treasury bond yield represents both a
measure of competitive asset class returns and also a policy
variable which impacts economic activity. Essentially, the
higher the bond yields are, the greater is the capacity of the
stock market. Why? Because bond yields have further to
decline. If bond yields are high, stock valuations, economic
growth and corporate earnings performance have greater
potential to improve should bond yields decline.
Third, is the labor unemployment rate. When the economy is
at less than full employment, it can improve growth without
creating negative consequences for the stock market. That
is, when there is ample slack, economic growth simply
absorbs unemployed resources without aggravating costpush pressures, inflation or the need to raise interest rates.
This type of economic growth often results in better earnings
performance, rising P/E valuations and policy officials
which can remain accommodative and supportive for the
stock market. However, once the labor market reaches full
employment, further economic growth begins to retard the
potential for stocks as cost-push pressures begin to challenge
profit margins, bond yields rise, P/E multiples decline and
policy officials are forced to begin tightening.

Economic and Market Perspective | December 15, 2015

Finally, a measure of future earnings potential is provided by

corporate profit margins. Initially, when exiting a recession,
profit growth is boosted both by a sales revival and by
improving profit margins. However, once profit margins
near historic highs, future earnings growth at best can only
approximate sales performance and may do worse if margins
erode.

The percentile ranking of the 10-year Treasury bond yield is

shown in Chart 2 (note, 100 represents the lowest bond yield
in post-war history whereas 0 represents the highest yield).
Clearly, after a 35 year secular decline, bond yields have
exhausted their potential to fall. They could of course remain
very low for several years, but they are not likely to decline
much further.

While other factors are also arguably important when

accessing stock market potential, these four aspects provide a
reasonable characterization of the possibilities for an advance
in stock prices. Indeed, other factors may be embodied by
these four. For example, investor sentiment is probably
captured by valuations. A bullish sentiment is reflected by a
willingness to pay up for stocks. Similarly, the unemployment
rate and the level of bond yields probably reflect the impact
of economic policies.

It is interesting to compare the 1950s bull market to that of

the 1980s. At the start of the 1950s, even though bond yields
were already near maximum capacity for the stock market
(i.e., bond yields could not fall much lower), stocks still did
quite well in the 1950s even though bond yields rose. This
was because while yields were at maximum capacity, the P/E
multiple (Chart 1) began that decade near record lows. So
the stock market rose despite no yield capacity because it
possessed outsized valuation capacity. By contrast, the 1980s
bull market was initiated with maximal excess capacity in
stock market valuations and in bond yields.

Overall, the future potential of the stock market depends on

what can yet be improved. Can P/E multiples still rise? Can
inflation or interest rates still be lowered? Can economic slack
still be reduced boosting the pace of economic growth? And,
can profits still be enhanced? If P/E multiples are near highs
when bond yields are near lows, if the economy is already
near full employment and if profit margins have already been
maximized, what can be improved to keep stock prices rising?

Components of stock market capacity

Exhibit 1 illustrates the four components used to estimate the
stock markets capacity utilization rate. In each case, the factors
are shown as percentile rankings for the entire post-war era.
Chart 1 shows the percentile ranking for the S&P 500 P/E
multiple. Currently, the P/E multiple is in the 75th percentile of its
range during the post-war era. That is, the current P/E multiple
at about 18.5 is higher than 75% of the time since WWII. It is also
lower than 25% of the P/E multiples since 1945. As shown, the
highest P/E multiple was at the dot-com top in 2000 and the
lowest P/E multiple was in the late 1940s.
Although the P/E multiple is in the upper quartile of its historic
range, it could still move higher. That is, the stock market still has
some valuation capacity. However, some of the P/E multiples
above todays level were primarily the result of a temporary
collapse in earnings (e.g., the early-1990s and the spike in
2009) caused by a recession and consequently, the current P/E
multiple may be closer to capacity than this chart implies.

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The percentile ranking of the unemployment rate shown in

Chart 3 approximates the degree of slack left in the economy.
A low percentile reading on this chart (i.e., a high labor
unemployment rate) signifies considerable capacity for the
stock market to be boosted by improved economic growth
without significant inflation or interest rate pressures. As
shown, the current unemployment rate is about at the 70th
percentile of its historic range. While the unemployment rate
could still improve, a further decline in the unemployment
rate below a 5% rate (i.e., a further rise above a 70 percentile
ranking) will likely produce some cost-push pressures and
higher inflation and interest rates. That is, the capacity for
further declines in the unemployment rate which prove
favorable for the stock market is probably getting limited.
Finally, the capacity of the profit cycle is illustrated in Chart 4.
Profit margins reached a post-war record early in this recovery
and have since remained very high by historic standards.
While profit growth has been boosted both by a sales revival
and by margin enhancements throughout this recovery,
Chart 4 suggest profit performance is now increasingly reliant
on sales growth. Moreover, even better sales results could
be curtailed in future quarters should companies experience
some profit margin erosion.

Economic and Market Perspective | December 15, 2015

Exhibit 1 -- Components of utilization rate

Chart 1

Chart 2

Price earnings multiple

U.S. stock market capacity utilization rate*

10-year Treasury bond yield

U.S. stock market capacity utilization rate*

*Percentile ranking of the S&P 500 trailing 12-month P/E multiple in

the post-war era (100 is the highest P/E multiple and 0 is the lowest
P/E multiple).

*Percentile ranking of the 10-year U.S. Treasury bond yield in the postwar era (100 is the lowest yield and 0 is the highest yield).

Chart 3

Chart 4

Labor unemployment rate

U.S. stock market capacity utilization rate*

Corporate profit margins

U.S. stock market capacity utilization rate*

*Percentile ranking of the U.S. unemployment rate in the postwar era (100 is the lowest unemployment rate and 0 is the highest
unemployment rate).

*Percentile ranking of U.S. corporate profit margins in the post-war

era (100 is the highest margin and 0 is the lowest margin).

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Economic and Market Perspective | December 15, 2015

Stock market utilization rate

The stock market capacity utilization rate is the result of
combining these four factors into a single indicator. Chart 4
represents the average of the historic percentile rankings of the
P/E multiple, the 10-year bond yield, the labor unemployment
rate and the corporate profit margin.
As shown, even though the P/E multiple is still lower than 25%
of the time in post-war history, the overall stock market capacity
utilization rate is currently at a post-war record high slightly
above 80! While the P/E multiple may be below post-war highs,
it has never been this high when bond yields are near postwar lows, the economy has returned to full employment and
company profit margins are near maximal levels.
While a record high stock market capacity utilization rate
does not necessarily indicate an imminent bear market, it
does suggest much lower return potential during the rest of
this bull market.

Chart 6 illustrates the average future one-year forward percent

gains in the stock market from each decile in the capacity
utilization rate. The capacity utilization rate was less than 10
for only a couple years in the early 1980s and the one-year
forward returns were spectacular. On average, the annualized
gain in the stock market was more than 27%! As shown in
Exhibit 1, in the early-1980s, there was great potential to
improve every aspect of the stock markets capacity utilization
rate. P/E multiples were near record lows, bond yields were at
record highs, the unemployment rate was way above norms
and corporate profit margins were hovering about post-war
lows. Even though it was only for a brief period of time, when
there was so much capacity to improve conditions in the stock
market, stock returns were stellar.

Chart 6
1-year forward average stock market price gain by stock
market utilization rate.

Chart 5
U.S. stock market capacity utilization rate*
*Average percentile ranking of P/E multiple, profit margin, bond yield
and the unemployemnt rate.

Stock market utilization rate

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Economic and Market Perspective | December 15, 2015

Chart 7

Future one-year stock returns have mostly been linearly related

to the degree of stock market capacity. For example, when the
stock market capacity utilization rate was below 50, average
annual stock price gains were solid between 11 and 12% (an
exception was when the capacity utilization rate was between
30 and 40 and inexplicably stock market gains declined to
about 7.8%). And as the utilization rate rose above 50, average
stock price gains declined. Indeed, when the utilization rate
was between 60 and 70, future average annualized stock price
gains were only 6.7% and when the utilization rate was above
70 (as it is today), average one-year forward stock price gains
have only been about 3.5%.

Percent of annual stock price returns below 1-month T-bill

return* -- by stock market utilization rate.
*Average percent when stock market utilization rate is 70% or less is 34.4%.

The importance of the utilization rate on future returns is

also highlighted in Chart 7. It shows the percent of forward
one-year stock price returns that were less than the 1-month
Treasury bill return for each utilization rate. That is, how
often did cash outperform the stock market? On average,
when the stock market capacity utilization rate was less
than 70, cash outpaced one-year forward stock gains about
one-third of the time. However, when the utilization rate has
been above 70, cash returns have outpaced stock price gains
about 46% of the time!
Stock market utilization rate

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Economic and Market Perspective | December 15, 2015

Summary and conclusions

At best, the major factors underlying the stock market

will simply maintain their respective lofty hospitable
levels. Less optimistically, some of the foundations for the
current bull market may begin to weaken. Consequently,
investors should adopt a more conservative outlook (if
not yet bearish) for a stock market exhibiting the highest
capacity utilization rate of the post-war era.

The stock market capacity utilization rate introduced

here is not offered as a timing indicator. We are not
suggesting because it is currently at a post-war high that
a bear market is imminent. Rather, it focuses attention on
how much potential is left in this bull market. Whether
the bull market lasts several more years or only a few
months, its ultimate upside from current levels is probably
significantly less than post-war norms. The record high
stock market utilization rate suggests the best returns are
long past for this bull market.
As the utilization rate suggest, the stock market has already
used up much of its capacity to rise. Valuations may not be
record setting, but they are fairly high. Falling bond yields,
a primary catalyst for the bull market during the last 35
years is all but exhausted. Because the economy is now near
full employment, additional improvements in the pace of
economic growth will likely come only with broader costpush pressures, higher inflation, increases in bond yields
and greater pressure on profit margins and P/E valuations.
Finally, the corporate profit recovery is well past its best for
this cycle. Profit margins have no room to rise further and
emerging pressures may erode margins thereby largely
offsetting any material improvements in sales performance.

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.

The U.S. stock market has already risen three-fold in this

recovery. This has been due to a massive recovery in profits,
a return to full employment in the economy, a large decline
in and persistently lower bond yields and a major advance in
the stock markets P/E multiple.

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