Wells Capital Management

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Economic and Market

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January 4, 2016

Some Thoughts on 2016

A synchronized global economic bounce?
James W. Paulsen, Ph.D
Chief Investment Strategist,
Wells Capital Management, Inc.

Welcome to 2016! Because of its persistent subpar growth rate,

the contemporary economic recovery is universally considered
disappointing. However, if it continues until March, it will
represent the fourth longest in U.S. history. The stock market
bull is already the fifth longest and its gain is the fifth best
(about a three-fold rise) in U.S. history. Both U.S. nominal GDP
and nominal personal income are currently about 25% above
their respective levels at the end of the last recovery. There
are more people currently employed in this country than ever
before and the unemployment rate recently returned to 5%,
a level which is lower than two-thirds of the time since WWII.
Finally, both corporate profits and household net worth (at
about $85 trillion) are at all-time record highs about 25% above
their previous respective peaks reached in the last recovery.
While this may be the most disappointing recovery ever, it is
also likely the most successful disappointing recovery ever.
While overall economic growth this year will likely remain subpar
by historic standards, our guess is the global economy will enjoy
its first synchronized bounce in real economic activity of the
recovery. This probably will be led by a recovery in the materials,
energy, and manufacturing sectors due to a lagged response
from powerful economic stimulus introduced about the globe
during the last year. While better economic growth should be
supportive for most stock markets, it may prove conflicting
for the U.S stock market. After a widespread obsession
about the potential for a global deflationary abyss, most
inflationary indicators may lift in 2016. The first synchronized
global economic bounce since the U.S. has returned to full
employment, a surprisingly weak U.S. dollar, a revival in
commodity prices, and worsening wage pressures may combine
to accelerate the Feds exit strategy and pressure fixed-income
markets around the globe.
Here are the details of several guesses for 2016.

Not only has global economic growth been persistently subpar,

it has never been synchronized. Early in the recovery, while the
U.S. chose quantitative easing aimed at improving economic
growth, the eurozone chose fiscal austerity pushing the region
back near recession. Moreover, in late 2010, Chinese officials
decided to moderate their recovery and emerging world
growth has been slowing ever since. Japan has been up and
down throughout the recovery and in the last couple of years,
resource-based economies like Canada and Australia have
slowed as oil prices collapsed.
This could be the year when all economic boats finally rise
together. During the last 12 to 18 months, powerful economic
stimulus has been implemented nearly everywhere. First, the
collapse in most commodity markets including energy prices is
similar to a major fiscal tax cut. Globally, there are many more
consumers than producers of commodities and an almost 50%
reduction in broad-based commodity price indexes since 2014
will likely prove to be a major economic stimulant. Monetary
accommodation has also been evident. Long-term sovereign
bond yields have declined significantly in the U.S. and Canada,
throughout Europe, in Japan, and across the emerging world.
Finally, relative to the U.S., many foreign currency rates have
recently been cheapened by about 20%.
Overall, most economies have enjoyed a powerful trio of policy
accommodation the equivalent of a major fiscal tax cut
(lower commodity prices), a significant monetary boost (lower
bond yields), and a large currency devaluation. Rather than
anticipate further global weakening this year, the lagged impact
of these aggressive economic policies suggest better economic
growth.
Unlike most economies, the U.S. faces a stiff headwind from a
substantial rise in the U.S. dollar. However, this negative force
should be buffered by a deep drop in commodity costs and
by lower long-term bond yields. Moreover, the U.S. economy
is likely to benefit from other private sector forces during
2016. First, until 2014, the U.S. economy had little or no credit
creation. In the last year, though, U.S. bank lending has risen by

Economic and Market Perspective | January 4, 2016

more than 8%! Perhaps some leveraged economic activity will

allow the recovery to grow a bit faster?

Closing the global gap and reversing the U.S.

dollar!
The U.S. dollar has played a crucial role in both the financial
markets and in the economy during the last couple years. We
expect it will again be a central driver of events in 2016.

Second, the U.S. household sector is in far better shape

compared to any other time in this recovery. When the
recovery began, the unemployment rate was over 10%, job
creation was paltry, household net worth had declined by
about 20%, and consumer confidence was near a post-war low.
Today, the unemployment rate is only 5%, annual job growth
has consistently been close to 2%, household net worth has
risen by more than 50% from its recession low, and consumer
confidence measures are much closer to post-war highs.
Moreover, real wages have risen faster this past year (by about
1.6%) than at any other time in this recovery. Lastly, since the
Fed has begun to raise interest rates, savers should finally be
rewarded with rising interest income.

Most seem to believe the U.S. dollar has strengthened

because of the difference in economic policies between the
U.S. and the rest of the world. Indeed, with the Fed already
beginning to raise interest rates while most foreign officials
are intensifying easing efforts, a strong consensus expects the
U.S. dollar will continue to advance.
However, the economic growth differential, rather than policy
differentials, is likely more important in driving currency
valuations. In 2014, while U.S. economic growth improved
slightly, growth abroad mostly slowed. The widening growth
gap between most foreign economies and the U.S. pushed
the U.S. dollar considerably higher during the last half of
2014. Since last February, however, the dollar has trended
sideways against most developed economy currencies
as U.S. economic growth slowed slightly while growth in
some developed countries like Japan and the eurozone
improved. U.S. dollar strength during 2015 was mainly limited
to emerging currency rates as growth in China and most
emerging economies continued to slow.

Third, expect a greater contribution from the housing industry

during the balance of this recovery. Normally, the housing
market is an early cycle contributor often weakening again
long before the recovery ends. In this cycle, however, housing
was a no-show early in the recovery and may oddly prove to
be an outsized late cycle contributor. Due to the severity of the
last recession, many home plans were postponed but perhaps
not canceled. Now that the job market is much improved,
consumer confidence has recovered, household formation is
finally rising again, and the Fed is signaling homeowners need
to act soon to beat mortgage rate hikes. U.S. housing activity
may prove stronger than most anticipate.

We expect a synchronized global economic bounce to

close the foreign growth gap relative to the U.S. and force
the U.S. dollar lower this year against both developed and
emerging currencies. While U.S. growth should improve
slightly, we think it will bounce less than most foreign
economies for a couple of reasons. First, the U.S. did not slow
as much as most international economies in recent years and
therefore probably has less rebound potential. Second, the
U.S. economy is closer to full employment limiting growth
potential relative to foreign economies with more resource
slack. Most importantly, foreign policy officials have recently
been much more accommodative compared to domestic
economic policies (e.g., the Fed stopped quantitative easing
in 2014 and just began raising short-term interest rates last
month), and finally, the U.S. bounce is likely to be muted in
part due to the lagged impact of a strong dollar.

Finally, capital spending may help boost U.S. growth this year.
Throughout this recovery, corporations have been sitting on
considerable cash hoards which have been used primarily to
boost dividends, increase stock buybacks, or for mergers and
acquisitions. There has been little incentive for capital spending
when most global economies were often struggling. However,
if there is a global synchronized economic bounce in 2016, it
could finally awaken the animal spirits of cash rich companies.
We do not anticipate booming economic growth. Aging
demographics in the developed world and poor productivity
performance are the two primary obstacles likely to keep
growth subdued. However, if most economies simultaneously
improve even marginally, the overall global recovery may
appear broader, healthier, and more sustainable than ever.

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Economic and Market Perspective | January 4, 2016

One last comment about the U.S. dollar. Many believe since the
Fed has begun to raise interest rates while most other foreign
policy officials remain highly accommodative, the U.S. dollar can
only rise. However, in contrast to conventional wisdom, since at
least 1970, when the Fed funds interest rate has increased, the
U.S. dollar has typically declined. Moreover, if global economic
growth improves, interest rates will likely rise everywhere.
Quantitative easing does not ensure bond yields will stay
low. The U.S. was employing quantitative easing in 2013 when
improved U.S. economic growth boosted the 10-year Treasury
bond yield that year from about 1.5% to 3%.

We are not suggesting nor are we concerned about the risk of

a significant sustaining burst of inflation in the U.S. or about
the globe. We do believe, however, that widespread worries
about deflation will lessen this year and perhaps for the first
time in this recovery, the cultural mindset (particularly within
the U.S.) will start to recognize and accept that the inflation
environment is beginning to turn higher. The U.S. crossed over
into some semblance of full employment this past year with
the unemployment rate falling to 5%. Consequently, economic
growth will now likely aggravate cost-push pressures including
wages and core consumer prices. Moreover, these pressures
could intensify should the U.S. dollar decline, should commodity
prices including energy prices recover, and should global
economic growth experience a synchronized bounce.

A weaker U.S. dollar and a recovery in

commodity prices?
Commodity markets are poised to have a good year in 2016.
The two major factors responsible for the decline in commodity
prices since mid-2014 weaker global economic growth and a
strong U.S. dollar should reverse this year.
Nearly every major decline in the commodity markets since
1970, rather than persisting at lows for an extended period,
experienced a sharp V-shaped recovery once a low was
reached. We suspect this will happen again this year and
although commodity prices are not to likely recover to the 2014
summer levels, their bounce may be much steeper than most
now anticipate. For example, we would not be surprised if crude
oil prices reach as high as $65 to $70 sometime in 2016.

We anticipate the annual rate of U.S. wage inflation to reach

about 3.25% this year and for core consumer price inflation to
reach about 3%. While this level of inflation is not frightening
by historic standards, it would likely have considerable impact
on the mindsets of investors, consumers, businesses, and policy
officials which have grown complacent in a recovery seemingly
absent of any inflation risk. It is also an inflation rate probably
inconsistent with a 0.25% to 0.5% Fed funds interest rate, a 2.25%
10-year Treasury yield and with an 18 to 19 times trailing stock
market price-earnings multiple.

A challenging Fed tightening cycle?

Many believe lifting interest rates off zero should not be that
negative for either the economy or the financial markets. After
all, interest rates are still very low by historical standards and
this is more about normalizing monetary policy than it is about
tightening credit conditions. For a couple of reasons, however,
we expect the normalization of interest rates to prove more
challenging than most anticipate.

Core inflation to rise about the globe?

Primarily because of the collapse in energy prices, overall
inflation has slowed significantly. However, core consumer
price inflation has already increased more broadly than
most appreciate. Awakening core pricing pressures are most
pronounced in the U.S. being at least somewhat bolstered by
a return to full employment. The annual rate of core consumer
price inflation rose from about 1.5% to 2% this past year. Annual
U.S. wage inflation (based on a 3-month moving average)
recently rose to its highest level of the recovery to about 2.5%.
Finally, the U.S. core services inflation rate spiked to a new
recovery high this past year near 3%.

First, because the Fed has started the tightening process so

much later compared to past recoveries many of the buffers that
traditionally have mitigated the negative impact of rising yields
have expired. Usually, when the Fed first begins tightening, the
U.S. earnings cycle is much younger than it is today. Typically,
profit margins are far from cycle highs, company earnings
are still recovering from the last recession, and solid earnings
growth buffers early interest rate hikes. Today, the Fed faces an
old earnings cycle with profit margins already near post-war
highs. That is, the earnings buffer has already expired.

Core pressures have also quietly become more noticeable

about the globe. In the eurozone, the core consumer inflation
rate declined steadily between 2012 through the end of 2014.
However, the annual core inflation rate this year has risen from
about 0.5% to about 1%. In Japan, core consumer prices were
chronically deflating during this recovery until 2014. However,
they have risen by about 1% in the last year. Even in China, the
core consumer price inflation rate has accelerated by about
0.5% since late 2014.

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Economic and Market Perspective | January 4, 2016

Similarly, the Fed usually initiates tightening against solid

gains in the job market. Job growth is strongest when the
unemployment rate can be reduced. Once full employment
is reached, job gains typically slow. Today, as the Fed begins
to lift interest rates, job creation is likely to slow because the
unemployment rate is already back to 5%. For comparison,
during the last three initial Fed tightenings in April 1983, January
1991, and in May 2004, the unemployment rate was 7.9%, 6.6%,
and 5.6% respectively. Consequently, today, because the Fed has
delayed the tightening process, it has lost the opportunity to lift
interest rates against the most robust job gains of the recovery.

recovery? Could the normalization of interest rates initiated by

the Fed last year broaden to include the overall bond market?
Dare we say (again), we think so?
As we begin the new year, a dominant interest rate mantra
is lower for longer. This reflects a consensus that has come
to expect bond yields will never rise significantly again. The
global economy is very weak, inflation is nonexistent, and
deflation is a much bigger risk. However, we think several
things are changing which increases yield risk.
First, since the 2008 crisis, perhaps for the first time since
global inflation peaked in the early 1980s, the entire world has
thrown inflation concerns to the sidelines and is universally
focused on ending deflationary pressures. Even the historic
global epicenter of inflationary hypochondria, Germany, is
now fighting deflation. Chancellor Angela Merkel is no longer
demanding fiscal austerity but rather is standing down while
Mario Draghi employs full out quantitative easing. After
facing more than two decades of chronic deflation in Japan,
Abenomics has fully embraced the Benanomics playbook.
And China is no longer attempting to moderate its recovery.
Even the U.S. Fed was dragged only very reluctantly toward
monetary tightening and ensures all who want to listen that
they intend to move only very slowly. When the world
universally fought inflation in the early 1980s, they succeeded.
Perhaps the recent global war on deflation will indeed mark
the low in bond yields?

Finally, former Fed Chairman Alan Greenspan was considered

the Maestro of monetary policy primarily because he was able
to use a massive productivity miracle as the exit ramp (and
fabulous buffer against higher interest rates) for his monetary
normalization process. Fed Chair Janet Yellen, however, begins
the process of lifting interest rates against the worst productivity
performance of any recovery in post-war history.
We are also concerned that the premise behind this tightening
cycle may become stagflation. Indeed, wasnt this essentially
why the Fed finally began to raise interest rates in December?
It certainly wasnt because real growth was surging. The Fed
started to raise interest rates last month despite a recession in
the manufacturing sector because at full employment, concerns
about emerging wage pressures forced the decision. Sluggish
real economic growth has been a chronic problem in this
recovery but it has yet to be combined with inflation worries.
However, since the U.S. has now reached full employment, even
sluggish economic growth may produce cost-push pressures
resulting in wage and core price hikes. Typically, when the
Fed begins to tighten, although inflation pressures may be
intensifying, real economic growth is also usually firming and
much stronger than it is today. Could real economic growth
remain subpar while inflationary evidence strengthens? That
is, could the Fed be forced to quicken its exit path because of
stagflation fears?

Second, the synchronized policy stimulus delivered about the

globe in the last year (massive decline in commodity prices,
major declines in sovereign bond yields and widespread
currency devaluations) will likely produce a global economic
bounce this year when most investors are braced for weaker
economic growth. Third, the U.S. economic recovery has
returned close to full employment. Until now, economic
growth has not aggravated inflationary pressures. As the U.S.
dips into a four-handle unemployment rate, even continued
subpar real growth will now likely produce cost-push
pressures and higher wage and price inflation.

A bad year for bonds?

Throughout this recovery, a majority of prognosticators (author
included) have frequently anticipated an imminent rise in bond
yields. After all, a 10-year Treasury bond yield often only about
one-half the pace of nominal GDP growth hardly seems an
equilibrium interest rate. However, bond yields have mostly
either stayed low or moved even lower about the globe. Will
2016 finally be the year when bonds quit being priced solely by
fears and yields actually begin to reconnect with the economic

Finally, inflation concerns could be excited this year if

commodity prices bounce more than most expect and if the
U.S. dollar experiences a surprising decline. Should wage and
core consumer price inflation rise to about 3% as we expect, the
10-year U.S. Treasury yield may reach about 3.25% by year-end.

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Economic and Market Perspective | January 4, 2016

Another violently flat year for U.S. stocks?

there really a goldilocks economic growth rate for stocks?

It is tempting to suggest the stall in the stock market last year

is either a precursor to a bear market or that the bull market
will regain its footing and have another solid year in 2016. Our
guess though, similar to 2015, is for the U.S. stock market to
exhibit another year of considerable volatility while essentially
ending flat. The stock market faces several challenges it will
likely struggle to navigate in 2016.

Third, as we detailed in a report last year (see the Economic

and Market Perspective from October 13, 2015), history suggests
the character of the financial markets is typically far less
rewarding once the U.S. economy reaches full employment
(i.e., reaches about a 5% unemployment rate). Indeed, in
the post-war era, the U.S. economy has been at or below a
5% unemployment rate about one-third of the time. When
it has been at full employment, average annualized stock
returns have been nearly half what they were when the
unemployment rate was above 5%. Moreover, both stocks
and bonds have tended to suffer more frequent monthly
declines in fully employed economies. Finally, on average
during the post-war era, once the unemployment rate reaches
5%, the next recession has been less than two years away.
The bull market may yet last for several more years. However,
since the U.S. economy has returned to full employment,
history suggests investors should prepare for a much more
challenging financial market risk and reward environment
during the balance of this recovery.

First, while the stock market did pause in 2015, it was not a
refreshing pause. A year ago, the stock market entered 2015
with a relatively high historic valuation, with bullish or at least
complacent investor sentiment, with a rapidly aging earnings
cycle and with an imminent need to reset interest rates. As
we begin this year, many of these same challenges are still
evident. Since earnings were also essentially flat last year, the
pause in the stock market did little to improve its valuation.
While investor optimism may be somewhat less compared
to the start of last year, it seems mostly complacent. Indeed,
the brief correction last summer followed by a sharp recovery
did not generate much fear. Rather, it probably reinforced
buy on the dip mentalities and that any decline is simply an
opportunity rather than a risk. Like last year, the best earnings
performance for this recovery is already past. The U.S. earnings
cycle got one year older, corporate profit margins near postwar highs have no room for additional improvement and
since the U.S. has reached full employment, margins may
be pressured this year. Finally, while the long overdue U.S.
interest rate reset has finally begun, it is only about one month
underway. In 2015, the stock market constantly struggled with
when the Fed will begin to raise interest rates. In 2016, it will
likely constantly struggle with how fast interest rates will be
raised. It may be a new year, but the factors that essentially
flattened the stock market last year still appear equally
daunting and yet unaddressed here in 2016.

Fourth, we do think stagflation is a risk for the financial markets

in 2016. Until now, the stock market has constantly had to
deal with a subpar real growth recovery but not one with any
inflation overtones. Could 2016 be the first year of this recovery
when the financial markets face continued sluggish growth
with some inflationary worries? What if commodity prices
bounce, the U.S. dollar weakens, and wage inflation accelerates
toward 3% but U.S. real GDP growth remains subpar near
2.5%? Because the U.S. is now near full employment, even
slow growth could intensify inflation evidence. So far, the
stock market has done well in this recovery with very sluggish
real economic growth. Will it continue to do well even if real
growth remains subpar but inflation finally increases? That is,
how would the stock market deal with mild stagflation?

Second, with the U.S. economy now back close to full

employment, what economic growth rate is good for the
stock market? Until now, most companies have been able
to augment sluggish sales performance with chronically
rising profit margins. Now, however, if the pace of economic
growth remains weak, since profit margins are already near
record highs and can no longer be lifted, earnings growth
will likely match disappointing sales results. Alternatively,
should the pace of economic growth accelerate forcing the
unemployment rate towards 4%, rising cost-push pressures
are likely to erode profit margins, offset sales gains, and keep
earnings performance subpar. What economic growth rate
are the bulls expecting? With the U.S. economy now near full
employment and with record high company profit margins, is

Lastly, has the U.S. stock market already used up much of

its capacity to rise? It has risen about three-fold from its low
in 2009 and in March it will enter the eighth year of its bull
run. Thus far, it has performed well primarily because it had
so much capacity for improvement in the wake of the last
recession including a massive rise in its P/E multiple, a big
decline in the competitive bond yield, a huge improvement
in the economy registered by a large drop in the U.S.
unemployment rate, and a substantial recovery in corporate
earnings. Now, however, because of its success in reducing
excess capacity, room for further improvement is becoming
limited. The P/E multiple is in the upper quartile of historic
norms, the unemployment rate is back to 5% and cant go
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Economic and Market Perspective | January 4, 2016

financial market fallout (e.g., cost-push pressures, inflation

and higher yields), bond yields are already at all-time record
lows, and profit margins are at post-war highs. Where is the
capacity for stocks to continue to move significantly higher?

Increasingly, economic growth will likely aggravate

wage and price pressures, curtail corporate profit
margins, and force interest rates higher. Consequently,
the U.S. stock market may continue to struggle this year
until it finds a lower valuation level more appropriate
and sustainable for an economic recovery which has
returned to full employment.

Refreshing the bull?

Since 1870, the U.S. stock market has rarely risen above or
sustained at a trailing 12-month P/E multiple much above
the 18 to 19 times the market is priced near today. The
few times when the P/E multiple rose above todays level
were mainly periods when the P/E rose primarily because
earnings collapsed, rather than due to a true rise in the
valuation of trend earnings. The single notable historical
exception was the 1990s when the P/E multiple on trend
earnings soared and sustained between 20 to slightly more
than 30 for several years. This unprecedented valuation
period was associated with a massive leap forward in
technological expertise (i.e., the new-era tech boom). It
produced a surge in productivity dampening inflation
and cost-push pressures and neutralizing the negative
impact of rising interest rates allowing stock market
valuations to climb. If this single exception from the last
150 years of U.S. stock market valuations can be repeated
than the contemporary bull market does indeed still have
considerable potential. However, the other 140 years of U.S.
history suggest the current markets P/E multiple is quite
high and this valuation level may be difficult to sustain in an
economy now at full employment.

What P/E multiple would be sustainable in a fully employed

economy? We are not sure but would probably become
much more bullish on the prospects again for the U.S. stock
market should the P/E multiple decline to about 16 times.
This P/E multiple leaves room for a rise in competitive
interest rates, for the negative earnings impact of some
erosion in profit margins, and for a less hospitable Fed. The
stock market could revalue quickly similar to the August
correction last year. Currently, with trailing 12-month
earnings per share for the S&P 500 Index of about $112, a
violent break to about 1800 would reach a 16 P/E multiple.
Alternatively, it could simply prove to be another flat year for
the stock market, but unlike last year, a year when earnings
increase. For example, if the S&P ended this year essentially
flat at 2050 while earnings rose to about $125, the P/E
multiple would be 16.4 heading into 2017.
If the stock market is revalued (e.g., if the P/E multiple
is reduced again toward the 16ish level), perhaps the
buy-and-hold bull market could resume. That is, from
a more sustainable valuation level, the U.S. bull market
could simply follow earnings higher. Assuming a modest
5% annualized earnings growth rate during the rest of
this recovery and adding the current dividend yield of
about 2% suggests the possibility of a buy-and-hold total
return of about 7% once and should the valuation of
this bull market be refreshed. Longer-term returns could
even prove better if the U.S can resurrect some solid
productivity growth. Healthy productivity gains would
dampen inflation and interest rate pressures and could
allow the P/E multiple to expand again as it did during the
last great productivity era in the late-1990s.

Until recently, the primary premise of this bull market has

been the ability of the economy to grow (even though at a
disappointingly sluggish pace) without creating negative
financial market fallout. Because of excessive slack, this
recovery has grown without creating labor cost pressures,
without raising the inflation rate, and without forcing
a hike in interest rates. If the economic recovery can
continue to grow without raising any challenge to record
high profit margins, with a perpetually accommodative
Fed, without raising the overall inflation rate, and while
continuing to maintain a zero short-term interest rate,
then the stock markets P/E multiple could be maintained
near historic highs. Indeed, perhaps the valuation could
even expand further.

Admittedly, there is nothing scientific about 16 times

earnings. Perhaps, the stock market will find good
support at 17 times or maybe it will need to adjust to 15
times? Who knows? As this entire note, it is guesswork at
best. However, as we begin the new year, the U.S. stock
market still faces some formidable challenges and until
it achieves a better fundamental footing (i.e., reaches a

However, last year as the unemployment rate declined

back to 5%, the recovery reached the threshold of full
employment. Further growth in the economy now will
only be achieved with some negative consequences for
the financial markets.
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Moreover, while U.S. policy officials are turning hostile,

international policy officials will mostly remain hospitable
toward the financial markets. Additionally, unlike the U.S.,
most foreign markets are not likely to experience negative
financial fallout from being at full employment. Finally,
because their economic recoveries trail the U.S., most foreign
companies are still in a much younger part of the earnings
cycle.

lower valuation level), it is not likely to sustain a meaningful

advance.

Some investment recommendations for the

new year!?!
We anticipate another volatile but essentially flat year for U.S.
stocks but would not be surprised if the S&P 500 establishes
a new record high sometime during the year. Our guess
is for about a 20% trading range between about 1800 and
2200 ending the year at 2050. U.S. and global bond yields are
likely to rise significantly this year resulting in disappointing
fixed-income returns. Commodities and other real assets may
provide the best investment returns in 2016. Finally, hedge
fund strategies may also experience a good year. Thinking
not only about the next year but also the next few years, we
offer a few investment recommendations.

Fourth, we recommend using contemporary stock market

volatility to slowly position portfolios for the next leg of this
bull market. As discussed in a recent note (see the September
17, 2015 Economic and Market Perspective), we think a shift
in economic pricing power from consumers to producers
is likely to unfold during the balance of this recovery. This
suggests a leadership change in the stock market may be
forthcoming from U.S. stocks to foreign stocks (since the
U.S. economy is much more consumer-centric relative to
most foreign economies) and from consumer stock sectors
to industrial or producer sectors. Relative stock price
performance tends to follow relative economic pricing power.
Consequently, we would use periods of strong stock market
rallies to lessen the portfolio exposure toward U.S. stocks
and toward consumer sectors (e.g., consumer discretionary,
consumer staples, and health care). Similarly, periods of
significant market weakness should be used to add overseas
exposure and to accumulate the industrial and capital goods
sectors (e.g., industrials, materials, energy, and technology).

First, while the U.S. stock market correction may not yet be
over, we would not tilt significantly away from equities. Cash
offers a near zero return and bonds also exhibit significant
risk during the balance of this recovery. Moreover, we
continue to believe the bull market is most likely pausing but
not ending. While buy-and-hold may prove difficult in the
coming year, it may also still prove profitable during the next
few years (particularly if U.S. productivity is resurrected).
Second, some modest cash reserves seem warranted. While
near zero returns are not necessarily attractive, we would have
some dry powder to take advantage of opportunities should
the U.S. stock market experience another correction this year.
Third, stock portfolios should be maximally tilted toward
international equities both developed and emerging stock
markets. The U.S. is in an almost unique position facing the
crossroads of full employment. Most other economies across
the globe are still in full policy accommodation mode. Should
global economic growth soon bounce as we expect, while the
U.S. stock market may struggle with escalating inflation and
interest rate pressures, improved economic growth would
be bullish across the emerging world, Europe, Japan, and
Canada. We find the international equity markets attractive
for many reasons. After four years of underperformance
relative to the U.S., international investing is under-owned
and most overseas markets represent a better relative value.

Fifth, we favor both mid and small cap stocks over large
cap stocks. In the U.S., the large cap marketplace has not
yet experienced any meaningful correction and is probably
more extended on a valuation basis. Moreover, disinflation
historically tends to favor large company stocks. Larger
companies tend to operate with fluff and wider profit
margins and are therefore better able to deal with tough
top line pricing competitiveness that often results during
periods of disinflation. Large companies can more easily cut
costs, promote efficiencies, and achieve economies to scale
to more effectively prosper in falling inflation eras. Smaller
entrepreneurial companies tend to run lean and mean and do
not have as much flexibility to widen margins. However, when
the inflation rate accelerates, small companies tend to have
much greater operating leverage to better top-line pricing.

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Economic and Market Perspective | January 4, 2016

Should inflation finally rise in this recovery as we expect,

profit growth among small and mid cap companies should do
much better relative to large companies.
Sixth, we believe the U.S. dollar is peaking and will likely
move lower in the next year. Last year, the U.S. dollar
strengthened significantly against emerging market
currencies but was essentially flat since January against most
developed world currencies. We expect a bounce in global
economies to close the growth gap between the U.S. and
the rest of the world resulting in a bid for foreign currencies
and a sell of the U.S. dollar. While U.S. yields will likely rise,
better economic growth abroad should also increase foreign
yields, keeping yield spreads from widening materially. The
likelihood of a weaker U.S. dollar is another reason investors
should consider lifting exposure toward international assets.

best year in commodities since early in this recovery. Overall,

if foreign economies finally experience a synchronized
recovery (even if growth is still only modest) while the U.S.
crosses over into full employment, real assets in general may
do much better during the rest of this recovery.
Eighth, a flat but volatile stock market and a challenging
bond market probably favor hedge fund strategies in 2016.

Seventh, consistent with a weaker U.S. dollar is an

expectation that we are near a bottom in commodity prices
(see the August 25, 2015 Economic and Market Perspective).
After collapsing in 2014, commodity prices have trended more
sideways this past year. A bounce in global economic growth
combined with a decline in the U.S. dollar could produce the

Finally, investors should remain underweighted in fixedincome assets. With most global policy officials now
simultaneously and robustly attempting to boost economic
activity, with the U.S. finally in policy tightening mode and
with bonds currently priced for expected weak growth with
deflationary overtones, the upside risk for global bond yields
remains elevated. We would focus bond allocations away
from the U.S. and toward lower credit quality, which has
recently become much more attractively priced.

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Economic and Market Perspective | January 4, 2016

Final conclusions
Most likely 2016 will prove to be a year which refreshes an
ongoing bull market by lowering stock valuations to more
sustainable levels. It also may finally begin to reconnect
interest rates more appropriately to an economy now at full
employment, with about a 2.5% to 3.0% real GDP growth rate
and about a 2.5% to 3.0% core consumer price inflation rate.
It is likely to further check and refresh investor complacency
built up over the last several years of mostly good markets.
And, it may rebalance some financial trends which have
moved to far out of line including the U.S. dollar, foreign
stock markets, and commodity prices.

Very few sectors seem overextended including housing,

capital goods, manufacturing, technology, or retailing. Finally,
yields have not risen aggressively, the yield curve is still very
positively sloped and liquidity is more than ample.
The stock and bond markets may be headed for a refreshing
year but the chance of some better productivity gains and a still
low probability of recession keeps us bullish longer-term. I hope
you have a sturdy fortitude to withstand what may prove to be a
challenging year but probably within the context of an ongoing
bull market.
Happy New Year!!!

The potential for this bull market to continue depends

primarily on two factors. The first is productivity. Better
productivity is not absolutely required to continue this bull
market, but it would certainly help. Without any meaningful
rise in productivity, full employment pressures are likely
to accelerate and eventually end this economic recovery
much sooner. Alternatively, some pickup in productivity
would buffer the need to raise interest rates, stretch the
labor market beyond full employment, and help dampen
inflationary pressures which would likely elongate both the
recovery and the bull market. While we do not expect any
productivity miracle like the 1990s, we do expect productivity
to do better in the next few years.
The primary reason we have not yet turned outright bearish
despite the many challenges currently faced by the stock
market is because we believe the risk of recession in 2016
remains quite low. Without a recession, a sustained bear market
is not likely. The normal excesses for recession are not evident.
Balance sheets among consumers and businesses are mostly
healthy and banks are the most strongly capitalized ever.

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.

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