Interview With James Paulsen
Chief Investment Strategist, Wells Capital Management
A YEAR AGO, JAJY.IES PAULSEN, STRATEGIST FOR WELLS Fargo's institutional investment advisory firm, Wells Capital Management in Minneapolis, broke from the pack: He predicted that small-caps would extend their outperformance, oil prices would drop and stocks generally would continue to deliver superior returns. Paulsen was right, of course.Now, he expects more of the same as global growth stays strong and interest rates remain at manageable levels. A maverick throughout his nearly 25-year career, Paulsen is accustomed to making bold calls. His clients haw the pleasm'e of seeing them borne out. And we give you the pleasure of hearing his views.
Barron's: We've come 180 degrees from last quarter in terms of sentiment. What do you make of the market and the economy?
Paulsen: A couple of months ago, there was the impres sion consumers were suffering under the weight of a stock market that was down 10% and being told everyday that their house values were going to hell. Mortgage yields had risen to their highest level of the cycle, job creation seemed like it was grinding to a halt and everybody,as paying $3 at the gas pump. It was a disaster. 00W, mort gage yields are back to where they were at the end of last year, the Dow Jones Industrial Average is at an ail-time high, [former Federal Reserve Chail'm2,n] ).1an Greenspan says the housing market has bottomed, and we found another 810,000 jobs we didn't knOw we had. Last night, when I paid $2.09 at the pump, it seemed cheap.
The nature of this whole recovery has been to switch sentiment every 120 days or so from concerns about an overheating economy to one headed for recession. But the undertow of the rally has been good throughout. In the short term we've come off the market lo\vs of June and gone to new highs. Longer term, this recovery cycle started in March 2003. Before the cycle ends or truly peaks, there's got to be some increase in long-term bor rowing costs. Right now, the lO-year-yield is at 4.80%, not much different from where it's been for four or five years. Yields were up to 5.25% in June but were promptly taken down again. One of the reasons the econ omy keeps going is we haven't sat on it with any kind of force, and some of the things that were biting at it have changed of late, mainly energy.
How long do low oil prices last?
In early September, I wrote that oil was going to break down and head back into the 40s because it is fairly valued around $50 a barrel based on what other commod ities have done. Commodities are up a lot because of world growth, but oil went up a lot more than the rest of them. If it had gone up about as much as non-energy commodities, it would be around $50 now. The excess pricing of crude has come about because of speculatiw risk premiums and not fundamental supply and demand forces. As some of those risk premiums diminish, crude is going to go back to aiundamental price level and it wiiI probably overshoot on the way clmV11 just as it over shot on the way up. I might get interested in that energy complex again if we break into the 408. There is still quite a bit of risk there for equity investors, but there is nothing bad about that for the economy. The Goldman Sachs non-energy commodity price index is within 2% of breaking above its May highs and going to new cycle highs, and it has been going straight up the last few weeks. It is possible we could have a new high in non energy commodity prices at the same time oil collapses. ti Watching that develop says a lot about oil, because if it p were truly a global slowdown that is causing oil to pull- back, as many people suggest, then it would also cause a y pullback in other commodities.
A lot of these fear stories get so far ahead of them- a selves and into the pricing of the markets. There were G worries about severe oil shortages and oil going to $100 J, a barrel, and I'm not Sill'e supply and demand ever got that bad. There's been a long litany of items to derail the economy al1d the markets. Remember the bird-flu pandemic? Remember the recovery? Remember, there was going to be a major as soon as the yield curve It has been inverted for a yeal' and no one mentions it any longer. Meanwhile, it will be another double-digit year for stock-mal"ket returns, and GDP [gross domestic product] growth is at 31;2% to 4%. Job creation has been over 2% and income trends are good. That is on a domestic basis. The story gets better when you look at global trends.
Yet, investors seem cautious.
I'm looking at a corporate sector that is making profits faster in this decade than any decade in the postwar era. It makes 'the 'Nineties profit miracle look paltry. The result is tremendous excess cash flow relative to capital-spending trends-it's off the charts and has been all decade long. Corporations have never made so much money, but they are also refusing to spend it. Every quarter they beat their numbers but say the future looks tough, just the opposite of the corporate culture that existed in 1999 and 2000. They are sitting on this boatload of buying power because they are cautious.
Investors, meanwhile, are happy with 5% money-market returns. No one cares that for the last four years running the stock market has beaten bonds and CCl.."h, by two to three times. The return for stocks ofl' the cycle lows is better than 10% a year. Cash has probably averaged 3% and bonds maybe 4% in that time. So here we've got this asset class that, for the past three or four years, has beaten cash and bonds by double and yet it is still the least favored.
Are you surprised the Fed took a time out in raising rates?
For a 'Seventies economics student trained on the Phillips Curve, I never thought I would ever hear the Federal Reserve in this country use the words "patient" and "measured" in the same sen tence with inflation ever. Yet those are the buzz words around their policy, hp cause they don't want to hurt the fragile economy. Never mind that commodity prices have had their biggest move of any cycle in the'postwar period. Never mind, we've never had more global powers con tributing to global growth, ever. Never mind, we have full employment and 82% capacity-utilization rates.
So you see a tightening down the road? We have got to go highm·. We have core inflation and we are going to have a little more of that. But to go back to my last point, I think bravado and optimism beg-PIs bad times and chronic cautiousness paints a beautiful picture for the future. It is a low-risk, high-return situation created by cautious players. If businesses aren't spent out, that implies they can drive faster growth in the future. If investors are sit ting in money-market funds, they can get enticed into the stock market as they keep reading about record highs. If policy offi cials want to be patient and measured, it just means they aren't stomping this sucker down and it. can grow harder for longer than anyone thinks.
How do you square this bullishness with the massive trade deficit?
The trade deficit is real debt because it is owned by foreigners and we have to pay them back. And while the trade deficit is at record levels, the more important record in my book is the number of con secutive years we've run a deficit: 15 continuous calendar years. To me, what we've been through in the last 15 years with our trade picture is equivalent to the Marshall Plan after World War II, which was directed at rebuilding war~torn Europe and Japan. At the time, it was highly criticized as throwing money down a rate hole. But it turned out to be one of the greatest investments in U.S. history be cause it is still paying dividends today.
Today's trade deficit is exactly the same thing; it is a massive stimulative policy aimed at jump-starting economies ancl utilizing previously underutilized re sources in the world. It has been an incredibly expensive policy. It has cost us jobs. It has cost us lost domestic spending growth for a decade and a half, and it is just now starting to bear fruit. Last year, our trade deficit with Malaysia represented 18% of their GDP. We gave China 9% of their GDP. In 2001 emerging-market consumption in U.S. dollar terms was 40% of U.S. con sumption. In '05 it was more than 50%. I am not saying where the money is being spent, just that in a few years the emerging ecqnomies will exceed U.S. consumption in dollar terms.
In a few years, we will have entirely cloned the U.S. consumer. That is, we are creating a world of middle-class shoppers. The concern has been the U.S. consumer has been the sole locomotive for world growth. Well, we are no longer the sole locomotive. We are taking the Mall of America out of Minnesota and putting it in Indonesia. When we look back on this pe riocl we are going to look back on it as a stroke of policy genius.
Policy or unintended consequence?
Totally unintended consequence.
Won't that put us at the mercy of others? People subconsciously realize the U.S. is no longer the world leader. But it is far better to be the third dog on a fast sled than the lead dog on a slow sled. We need to pass the torch to the areas that have the re"OUl'ce growth to maintain fast world growth. We are doing that, and it is a hetter deal for the next generation than trying to maintain a leadership position and grind worldwide growth to a halt.
What's your outlook for the trade deficit? In the next 25 years we are going to have slow but steady improvement in our trade deficit, and that is going to be the divi dend paY9ack for the long period of in vestment we made in these other coun tries. In the past several years, let's say, our domestic demand has been growing 5% each year while we lost about 1% abroad. So our real GDP is growing at 4%. Let's say next year the trade deficit improves by a percent and our domestic demand is still growing at 5%; well, then GDP grows at 6%. We can go from 4% to 6% without any change in domestic spend ing trends. You can imagine what that does to wage demands and interest rates.
What's your view on the dollar?
The dollar is going a lot lower. The dollar is off about 30% against the developed world, mostly against the euro. It has done very lit tle against Japan. It might be done weaken ing against Europe and Canada, but we've got a lot more coming against Japan and what hasn't even started yet is a move against the emerging economies. When these small economies become bigger play ers and want to play with the G-7, they are going to be required to do things that G-7ers have to do. There is no way China can continue to be a G-7 member and have a fixed exchange rate. We are in the pro cess of forcing them to come off that stan dard, and we'll be successful. If they want to play in the G-7, not only will they have to float their cm'rency but they will have to treat their employees better and put scrubberS on their factories. When we get through telling them all they will have to do to be in the G-7, we are going to find out their competitive standing won't be nearly as great as we think it is.
If the dollar is expected to go lower, shouldn't you direct money overseas?
Yes. The biggest risk in the bond market in the coming year is if the trade-weighted dollar breaks to new lows-below its 2004 lows-because when it does, non-energy commodity prices are going to go back to new highs, and that will feed into core inflation. Core inflation has already closed in on 3%, but if the dollar breaks, we're talking 4% core inflation and the interest rate structure cannot handle 4%.
What do you make of the private-equity boom?
It tells you how much excess liquidity we have in the system. The only reason to be a public company is for liquidity purposes, and there are plenty of companies saying they don't need liquidity. We've had three decades of pretty strong merger and acqui sition activity. The 'Eighties was debt based M&A. The 'Nineties was equity based M&A. And this cycle is predomi nantly cash-on-the-barrel based. The 'Eighties ended in a debt crisis. The 'Nineties ended in an equity crisis. Now, the question is how does a period fueled by cash mergers end? It ends in too many dollars chasing too few goods, and there is a risk of a melt-up in pricing.
What about the outlook for housing?
Greenspan has said the worst might be over for housing, and I have to agree. Refi nancing applications have exploded to the upside and are at the highest levels since last year. Lumber futures are showing signs of bottoming. Mortgage yields are back down. Housing stocks have been ris ing since July even though the reports have been bad. Construction jobs have been up about 30,000 in the last two months, despite the so-called housing collapse. '
Short-term there are a number of fac tors suggesting that things get better. Housing has rolled over and the economy is OK. Real residential housing is off about 1.2% in the last year, and yet over all GDP is up 3.6%. Year-to-date real hous ing spending is down over 5% at an annu alized rate in real terms and the economy is growing 4.2% year to date. There are really two separate housing stories at work, one gets all the. play and one doesn't. As residential housing has rolled over, non-residential construction is ex ploding to the upside. This tells you the slowdown in housing isn't primarily be cause of interest rates because higher rates would have also killed off commer cial construction, and it didn't.
How do small-caps fare in your scenario?
In this decade, the leadership has moved to the emerging economies. These coun tries are comprised of small companies mainly involved in cyclical or industrial pursuits. This cycle has been led by small cap stocks and industrial cyclicals, though everyone has been waiting for a rotation to large-cap stocks. If the leadership con tinues to be emerging economies, we may be surprised by how long small-caps con tinue to lead. This could be more of a secular play than a cyclical trade. If non energy . commodities go to new highs, what that says is the emerging story is back again and small-caps will do well.
But hasn't the shift to large-caps begun? Let's talk about that becau..'le I hear and read that everywhere. The Russell 2000 has beat the S&P 500 by 2% to 3% year to date. Large beat small for a period from the May high to about the June low, but not since then. The Russell 2000 has out performed the S&P 500 since mid-June. On days when the market is rallying, small has beat large for the most part.
I'm not saying we won't have periods where large-caps do well. But if growth continues at a pretty good pitch, this envi ronmentfavors smaller companies. Large caps dominated between 1980 and 2000, and that was because there was chronic dis inflation. Large companies have got the ability to deal with excessive price competi tion because there is more bloat for them to cut. Buta period of growth and pricing flex ibility benefits the smaller company be cause it all falls to the bottom line.
Thanks, Jim. _
