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Halftime Hunches???
It’s mid-year and both stocks and bonds are sporting solid
returns. Officially, due to a bizarre first-quarter real GDP
report (suggesting the economy collapsed at almost a 3%
annualized pace), the economy supposedly has not grown
so far this year despite the fact that almost 1.4 million jobs
were created!
Nonsense! We believe economic growth has been solid so far
this year as evidenced by numerous reports including strong
ISM manufacturing and non-manufacturing surveys, healthy job
creation, a persistently declining unemployment rate, continued
profit growth, the strongest bank loan growth of the recovery,
surging M&A deals, improved business capital goods
spending trends, robust auto sales, and a return to housing
starts running at an annualized pace above 1 million units.
Indeed, real GDP for the second quarter should exceed 3%
and we expect growth to remain north of 3% during the
second half of this year. With the S&P 500 near an all-time
record high of almost 2000, cash yields still near zero and with
a 10-year Treasury bond yield recently falling back to only
about 2.5% (even though the core consumer inflation rate has
risen to 2%), how should investors now be positioned? Here
are some “halftime hunches” for the second half.
Good news on Main Street has so far proved
good news for Wall Street!!
The primary foundation for the financial markets since early
2013 has been persistently better-than-expected news from
Main Street. Charts 1 and 2 overlay the stock market and
bond yields with Bloomberg’s U.S. Economic Surprise Index
(dotted line in both charts). The surprise index rises
whenever economic reports are better than anticipated.
Chart 2 shows the surge in economic surprise momentum
commencing about a year ago probably helped push the
10-year bond yield from about 1.5% to about 3% by the end
of last year. In early 2013, we believe a consensus was still
pricing the financial markets for an economy widely perceived
as stuck near a stall speed of about 2% growth. As information
from Main Street improved, both bond yields and stock prices
(Chart 1) had to be repriced. Indeed, notwithstanding a kooky
first-quarter real GDP number, the consensus now seems
to believe the economic recovery has notched up a peg to a
growth rate which appears much more “sustainable” around
3%. And as these charts illustrate, this newfound investor
mindset has driven both stock prices and bond yields higher.
Perspective Economic and Market
James W. Paulsen, Ph.D.
July 10, 2014
Chart 1: S&P 500 Index versus economic momentum
Left: S&P 500 Stock Price Index (solid)
Right: Bloomberg U.S. Economic Surprise Index (dotted)
Chart 2: 10-Year bond yield versus economic
Left: 10-year Treasury bond yield (solid)
Right: Bloomberg U.S. Economic Surprise Index (dotted)
Economic and Market Perspective

In the first quarter, as shown in both charts, the loss of
economic momentum (due primarily to nasty weather across
the country) impacted both the stock and bond markets.
Since March however, the spring thaw has again boosted
economic momentum and while the stock market has
responded, bond yields have thus far done little more than
bottom despite renewed evidence of economic vigor. This has
created an almost “Goldilocks” feeling in the financial markets.
Healthy economic growth keeps pushing stock prices higher
without aggravating the bond market. Consequently,
economic performance recently appears nirvana-like, not too
hot nor too cold! Can this continue?
Will good news on Main Street soon become
hostile for Wall Street?
The strong upward momentum evident in the stock market
could certainly continue. As the old adage says, don’t catch
a falling knife and don’t stand in front of a freight train. The
northbound bullet train which is the contemporary stock
market certainly has a head of steam and who knows how far
it will carry before a pause commences? There are not
currently significant, numerous, or obvious hurdles facing
stocks. Bond yields have declined this year, the Fed certainly
remains accommodative, inflation is still widely perceived as
benign, valuations may be extended but are far from
record-setting, and while investor sentiment may be getting a
bit complacent, it is hardly irrationally exuberant.
Our “hunch” though, is the second half of this year will prove
more troublesome for Wall Street primarily because it may
prove even better on Main Street. We believe investor con-
sciousness is shifting from worrying primarily about whether
the economy is growing fast enough to perhaps starting to
question whether Main Street may be growing too fast—
perhaps fast enough to raise inflation pressures, necessitate
higher yields, and accelerate the Fed’s exit strategy.
The most recent jobs report highlights this change in investor
focus. Until very recently, investors worried primarily and
incessantly about when the economy would improve enough
to produce jobs. Without sufficient job creation, the recovery
was always suspect and at high risk of renewed failure.
However, so far this year, monthly job gains have averaged a
strong 230K and the economy has managed to string together
five consecutive months of 200K+ monthly job gains for the
first time in this recovery. Moreover, the unemployment rate
has declined by more in the last year (by 1.4%) than at any
time in the recovery and at only 6.1% now stands only about
1% above what many consider full employment. Because of
recent consistency in job creation, investor anxieties seem to
have already shifted from worrying less about jobs to more
about wages. Mindsets are changing!
Indeed, how badly would the bond market have reacted to
last week’s jobs report when 288K jobs were created (against
about a 215K expectation) had the average hourly earn-
ings number (i.e., the monthly percent change in the wages)
risen by say 0.4% rather than the reported 0.2%? I think the
positive for stronger real growth implied by almost 300K
job creation may have been overshadowed by the cost-push
implications of the hot wage number bloodying both the bond
and stock markets. That is, the same basic jobs report with
just a bit stronger wage number could bring a totally different
investor response. Because of an evolving change in investor
mindsets, should real GDP growth stay north of 3% the rest
of this year keeping payroll gains at above 200K, we are
probably just a “single BAD wage number” away from
escalating inflation/overheat fears.
Most importantly, events which often lead to heightened
“overheat fears” have been increasing throughout this year.
Consider the following list of ingredients being slowly stirred
into a potentially powerful (2014?) overheat cocktail!
Economic and Market Perspective

1. The Fed continues to employ an unconventional, unprece-
dented, massively-stimulative, crisis-like monetary policy in an
economy which clearly is no longer in crisis and hasn’t been
for years.
2. Annual growth in the U.S. money supply is currently 6.6%,
4.6% faster than the annual core consumer price inflation
3. For the first time in this recovery, borrowing propensi-
ties (a central ingredient for more aggressive inflation) have
increased. Since year-end, total U.S. bank loans have risen
at almost an 8.5% annualized pace—the fastest growth in
bank loans of the entire recovery. Moreover, after declining
almost continuously during this recovery, total household
annual debt growth has now risen during each of the last
three quarters!
4. After remaining dormant for most of this recovery,
several major top-line inflation measures have accelerated.
Annual core producer price inflation has risen from 1.3%
to 1.8% in the last six months. Similarly, the annual rate
of core consumer price inflation has quickened from 1.6%
to 2.0% in the last three months. Finally, annual U.S. core
personal consumption expenditure inflation jumped from
1.1% to 1.5% in the last three months. While none of these
measures suggest inflation is escalating out of control, the
sudden change in direction is eye-catching!
5. After remaining benign throughout this recovery, some
indicators now show rising wage pressures. The NFIB
small business worker compensation plans survey recently
surged to its highest level in more than six years and annual
nonsupervisory wage inflation (comprising 80% of U.S. wage
earners) has accelerated from 1.3% to 2.3% in the last
20 months.
6. For the first time in the recovery, both the unemploy-
ment rate (soon probably falling below 6%) and the factory
utilization rate (currently at 79.1% and soon likely to exceed
80%) are nearing levels which historically have been
associated with cost-push pressures. Essentially, the
economic recovery is nearing a transition from mostly
“re-employing” idled resources to starting to “compete for
increasingly scarce resources.”
7. Finally, the CRB Spot All Commodity Price Index has risen
by about 10% from its early year lows. Even excluding volatile
energy and agricultural prices, the Journal of Commerce
Industrial Commodity Price Index has risen by more than 8%
from its lows last November.
We believe the U.S. economy has shifted to a higher gear
and will likely sustain at about a 3% growth rate during the
rest of this recovery. Although still a modest growth rate,
it is noticeably stronger compared to most of this recovery.
When combined with resource markets which are returning
closer to full employment, even 3% growth should start to
aggravate pricing pressures and, consequently, refocus Wall
Street attention on potential overheat fears. This new mind-
set may already be developing, and will likely broaden during
the rest of this year. Consequently, if Main Street remains
on a course toward more prosperous activity, Wall Street
is likely to become more treacherous as inflation anxieties
force bond yields higher, bring pressure on the Fed to
accelerate their exit strategy, and perhaps produce a
correction in the stock market.
Although cyclical stock market corrections are always difficult
to judge and even more precarious to time, what, if anything,
should investors do to survive what may prove to be a
temporary, but perhaps, more turbulent financial market?
Economic and Market Perspective

Don’t let a possible correction make you
miss the rest of this bull market!?!
We suspect both the stock and bond markets may become
more challenging over the next few months. But we also
know we could simply be wrong or just have bad timing
whereby trouble may not come till much later and from
much higher levels. So, the worst thing investors can do is get
too focused on the chance of a temporary correction and
miss the rest of this bull market.
While we sense a pause may be nearing in the financial
markets, we are much more confident in our longer-term
belief the current economic recovery and stock market bull
will likely last for several more years. Should investors really
be overly concerned about whether the S&P 500 Index will
soon suffer a 10% correction (e.g., from 2000 to about 1800)
if it eventually to rises toward 3000 sometime in the next
few years?
The contemporary economic recovery seems only in its mid-
dle innings. There are just too many aspects of the economy
which need to improve further before significant recession
risk emerges. First, as shown in Chart 3, the U.S. real output
gap (the percent difference between actual and potential
real GDP) remains at about -5%. Despite a recovery now
five years old, the output gap is still worse today than at the
bottom of most postwar recessions! It will likely take several
more years before this gap is closed. And, in postwar history,
the U.S. has never had a recession (combining the 1980 and
1982 recessions) before its real output gap was closed (i.e.,
before actual GDP rose “above” potential GDP).
Second, the U.S. has a large “confidence gap.” Most confi-
dence measures are still only average by postwar standards.
In our view, confidence is typically the central catalyst for a
recession. When economic players become confident they
engage in the type of excessive behaviors which necessitate
a recession. It takes confidence to over-spend, over-borrow,
over-lend, over-build, over-hire, over-tighten (the Fed), or
over-invest (in risky assets). None of these behaviors are yet
evident because confidence is still too low.
Third, the U.S. trade deficit is still about 3% of GDP, a
spending leakage which will likely improve before the next
recession. Fourth, due to the severity of the last recession, an
abnormally large pent-up demand gap is just now beginning
to be closed. Fifth, the U.S. has not yet begun to close its
“dry powder” gap. U.S. corporations have possessed outsized
liquidity in this recovery (cash sitting idle on balance sheets)
and are just now showing signs of initiating a new capital
spending cycle. Sixth, after almost five years of recovery, debt
propensities seem to finally be returning. That is, unlike past
recoveries, the economy is just now moving toward “cred-
it-driven” growth. Seventh, although stock market valuations
have improved from recession lows, the S&P 500 price-
earnings multiple is still only slightly above average and not
yet at excessive levels. Finally, a large “portfolio gap” is still
evident. Far too many investors allocated away from risk
assets in the aftermath of the 2008 crisis and have yet to
return to more a historically normal asset allocation.
Chart 3: U.S. real output gap*
*Percent difference between actual real GDP and potential GDP
Economic and Market Perspective

Many like to date recoveries on the basis of the calendar and
at five years old, this recovery is already among the longer of
postwar history. However, we think a better “age gauge” is
one based on “gaps” and on the actual behaviors of
businesses, consumers, investors, and policy officials. On
this basis, despite being in a recovery for five years, the gaps
remain too large and too prevalent and economic behaviors
simply too cautious to expect a recession anytime soon.
Indeed, because of the severity of the last recession (both
in terms of producing massive economic gaps and by gravely
damaging the psyches of economic and investment players),
we would not be surprised if the contemporary economic
recovery proves to be the longest ever in U.S. history.
If this economic recovery is not even half over yet,
temporary corrections notwithstanding, the upside potential
for the stock market during the next several years is probably
still substantial. Chart 4 highlights the imaginable. It overlays
the trailing S&P 500 price-earnings (P/E) multiple with the
consumer confidence index. Although not a perfect relation-
ship, the valuation placed on equities by investors is obviously
closely related to the level of overall economic confidence.
While confidence is no longer near postwar lows as it was
at the beginning of this stock market run, it remains only
average by historic standards. Since 1960, this confidence
measure has ranged between about 60 and 110. So far in this
recovery, confidence has improved from about 60 to about
82, or about 22 points of its 50 point historic range. If the
recovery does indeed last several more years, it seems likely
confidence will eventually reach a level near 100 where it has
peaked in several postwar recoveries. Based on the historical
relationship between confidence and P/E multiples shown in
the chart, a confidence level of 100 would likely produce a
P/E multiple between 20 to 22 times.
Current trailing earnings per share for the S&P 500 is about
$110. Assume in the next five years, annualized nominal GDP
growth is only about 5% (3% real growth and 2% inflation?).
Moreover, assume earnings only grow at 4% a year as
companies suffer some margin erosion. Even with these
conservative assumptions, in five years, earnings will be about
$135 giving a price range for the S&P 500 (with a P/E between
20 to 22) between about 2700 to 3000. From the current S&P
500 level near 1950, including dividends, this implies about a
10% total annualized return in the next five years. While this
is not a forecast, it does illuminate the potential in the next
few years which still exists for stock investors and the merits
perhaps of simply choosing to ignore short-term swings by
adopting a buy and hold approach!
Chart 4: S&P trailing P/E multiple versus consumer
Left: S&P 500 Stock Price Index, natural log scale (solid)
Right: University of Michigan Consumer Sentiment Survey,
natural log scale (dotted)
Economic and Market Perspective

Possible investment approaches for the
second half???
How should investors be postured today given the likelihood
of more turbulent financial markets in the second half of this
year but with ample appreciation also given to the significant
upside potential which may still be forthcoming for the stock
market in the next several years?
First, beyond normal diversification, one approach is to simply
ignore any short-term volatility which is difficult to accurately
predict anyway. Instead, be prepared to hold your nose and
keep the portfolio positioned for the expected longer-term
trends of rising stock prices and higher bond yields.
Second, even for those investors attempting to adjust port-
folios for a potential correction, we would not reduce the
portfolio overweight toward equities. The long-term potential
for the stock market is simply too significant to risk missing
by betting aggressively (by lowering the equity allocation) on
a temporary pullback. It is probably better to ride through a
potential 10% correction to ensure you fully participate in the
next 50% run.
Third, there is no compelling alternative to stocks. Should the
stock market suffer a correction in the next several months,
a primary catalyst will likely be rising yields. That is, while the
stock market may decline, long-term bonds may get hit just
as hard. Likewise, do you really want to bet heavily with cash?
An asset which currently sells at nearly 400 times its yield
flow (i.e., for every dollar invested you currently receive about
one-quarter of one cent annually!).
Fourth, we would increase the international diversification
of the stock portfolio. Since U.S. stocks have outpaced most
international markets in recent years, some offshore markets
are becoming relatively attractive. Charts 5 and 6 show the
prolonged and significant underperformance of both the
Canadian and Australian stock markets relative to the S&P
500. Both of these markets are much cheaper relative to
the U.S. than they were a couple years ago. Moreover, these
economies are more resource-based compared to the U.S.
economy which could gain investor favor should inflation
fears among domestic investors drive portfolio flows toward
commodity-based stock markets.
Chart 5: Relative price of Canadian versus U.S. stocks*
*Canada EWC ETF Index relative to U.S. SPY ETF Index
Chart 6: Relative price of Australia versus U.S. stocks*
*MSCI Australia USD Index relative to U.S. SPX Index
Economic and Market Perspective

Many of the international developed markets also offer in-
vestors a chance to diversify against the U.S. economic cycle.
For example, both Europe and Japan are currently lagging
behind the U.S. recovery cycle. Consequently, while U.S.
monetary policy has already begun to turn less
expansive, economic policies in both Japan and Europe will
likely remain accommodative for much longer. As shown in
Chart 7, although we currently like both European and
Japanese stocks, right now, Japan appears more attractive
relative to Europe.
Fifth, we continue to believe emerging economic growth
has bottomed and emerging stocks may regain global equity
leadership again in the next year. Investing in emerging stocks
is no longer as popular as it was a few years ago. Indeed, due
to their prolonged underperformance, many portfolios are
now probably underinvested in the emerging world. Chart
8 shows emerging stocks have equaled the performance of
the S&P 500 since year-end and seemingly reached a major
bottom in mid-March. Moreover, after underperforming for
most of the last few years, emerging market stocks have now
nearly matched the performance of the U.S. stock market
since last summer! Although growth in emerging economies
has slowed significantly in the last couple years (China is no
longer growing at 10%), even if emerging economic growth
sustains at the much slower 6 to 7% pace, it will still be at
least two times faster than sustainable growth in much of the
developed world. And currently, investors can buy this
premium sustainable economic growth rate at a large
discount (i.e., the P/E multiple on the MSCI Emerging Stock
Index is currently 13.5 versus about 18 for the S&P 500).
Sixth, it is probably time to “barbell” domestic equity
exposure. Throughout this recovery we have emphasized
overweighting stocks primarily in cyclical (economically
sensitive) sectors. We now advise diversifying sector
exposures among both cyclicals and defensives.
Chart 8: Relative price of emerging market stocks versus
U.S. stocks*
*Emerging Market EEM ETF Index relative to U.S. SPX Index
Chart 7: Relative price of European versus Japanese stocks*
*MSCI EMU ETF Index relative to MSCI Japan ETF Index
Economic and Market Perspective

On the cyclical side we would maintain overweight positions in
both technology and materials. We see evidence businesses are
finally beginning to ramp up capital spending plans, and as
illustrated in Chart 9, this tends to benefit technology stocks
more than any other sector. We also would keep an
overweighted position in materials stocks. As Chart 10 shows,
this sector typically does well whenever industrial commodity
prices rise. If, as we anticipate, U.S. economic growth remains
solid and domestic inflation fears intensify, both commodity
prices and commodity stocks may lead.
Chart 9: S&P 500 technology sector* relative price
performance versus capital goods spending as a percent of
*Since 1990, current S&P 500 infotechnology sector. Before 1990,
S&P 500 technology sector derived from industry composites.
Left: Relative price of S&P 500 technology sector (solid)
Right: U.S. capital goods spending as a percent of GDP (dotted)
Chart 10: Relative price performance of S&P materials
sector versus JOC Industrial Commodity Price Index
Left: Relative price of S&P 500 materials sector (solid)
Right: JOC Industrial Commodity Price Index (dotted)
Economic and Market Perspective

We also recommend overweighting a couple defensive
sectors—consumer staples and utilities. Chart 11 shows the
relative price of consumer staples stocks is near its low of the
entire recovery. Clearly, their slow but steady character has not
been very popular as economic growth has improved in the
last couple years. However, the relative value of this sector is
now attractive and the steady character of these stocks could
again become in vogue should investor anxieties increase if
the overall market becomes more turbulent. We also recom-
mend adding to the utility sector. As Chart 12 illustrates, the
relative performance of utilities tends to be closely associated
with bond yields. They do best when bond yields fall and often
underperform as yields rise. However, as shown, the relative
total return index of utilities is near its lowest level since 2006.
Indeed, they have done particularly badly since the 10-year
bond yield rose from about 1.5% to 3% last year. While we
expect bond yields to rise in the balance of this year, we also
think utility stocks may still do well. In the late 1990s and again
between 2003 and 2007, utility stocks performed well despite
rising yields. This was mainly because in both previous cases
they had already significantly underperformed before yields
rose, which they have again in the last couple years.
Chart 11: Relative price performance of S&P 500 consumer
staples sector
Chart 12: Relative total return on S&P 500 utilities versus
10-year Treasury bond yield
Left: Total return index S&P 500 utilities relative to total return
index of S&P 500 Index (solid)
Right: 10-year Treasury bond yield (dotted)
Economic and Market Perspective

Finally, a couple comments on the bond market. The 10-year
Treasury bond yield has declined this year after peaking near
3% late last year. This has produced a sense yields may remain
“lower for longer” even in the face of the end of the Fed’s QE
program and with 3+% U.S. real GDP growth. This may prove
to be true, but Chart 13 (unlucky 13?) is a good reminder
that bond yields could still rise significantly and quickly yet
this year. In 2010, the bond yield jumped by more than 1%
in about two months and last year the 10-year yield almost
doubled (from 1.63% to 3%) in about four months! Our best
guess is the 10-year bond yield may be near 3.5% by the end
of the year.
We would recommend bond exposure near parameter min-
imums. Until bond yields reconnect with the economic cycle
(i.e., are priced with a yield about 2% above core
consumer inflation which currently suggests about a 4%
10-year yield) and eliminate the huge “safe-haven” discount
they have carried as a legacy from the 2008 crisis, we think
bonds will represent a poor competitive value. For diversifi-
cation purposes, every portfolio should own some bonds. We
would recommend keeping below average durations and an
underweighting toward high quality. While many are
becoming concerned with how low junk bond yields have
declined, we still think they will outpace higher quality bonds
in the next several years. As Chart 14 shows, the high-yield
junk spread is currently about 429, but it declined to
between 300 and 350 in each of the last two recoveries and
persisted at that level until close to the next recession. Since
we believe the next recession is probably some years away,
the relative returns from lower quality bonds may prove
“better for longer” than most now appreciate.
Chart 13: 10-year Treasury bond yield Chart 14: JP Morgan Chase junk bond yield spread*
*Yield spread to worst on B-rated bonds
Economic and Market Perspective

We expect U.S. real economic growth to remain north of
3% the rest of this year, for the unemployment rate to soon
drop below 6%, for the factory utilization rate to soon rise
above 80%, for inflation fears to intensify, and for pressures
surrounding the Fed to escalate. In combination, this
environment will likely produce much more turbulent
financial markets. Our best guess is for the 10-year bond
yield to rise toward 3.5% perhaps causing a correction in the
stock market before the year is over.
We still find the longer-term outlook for stocks very
favorable and therefore would not lessen the secular over-
weight toward the stock market even though we would not
be surprised by a second half pullback. We prefer to diversify
the equity allocation (among international developed
markets, emerging markets, and by barbelling across both
cyclical and defensive sectors) while maintaining a secular
bullish overweighted position.
Throughout this five year bull market, the consensus has
persistently puzzled over why the stock market was doing so
well when Main Street was so bad. Indeed, the premise for
this remarkable five year bull market has been a chronic wall
of worry. Perhaps it really shouldn’t be surprising, therefore,
now when Main Street performance is finally perceived as
improved that Wall Street may experience at least a
temporary period of turbulence as it sorts out whether
inflation is a real concern and considers exactly how the Fed
will respond?
Economic and Market Perspective
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, 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 | | ©2014 Wells Capital Management

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