Paulsen's Perspective

Inflation plays a part in nearly all economic cycles. Once a new recovery gains footing, inflation starts rising, overheat fears intensify, policy officials respond, and bond yields increase. However, significant inflation—the type that becomes the centerpiece of an economic expansion—is a rarity.

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Despite a bear market, small-cap stocks have essentially been market performers this year. The S&P 500 is off by 17.8%, while the S&P 600 Small Cap Index is about the same (-18%). The Russell 2000’s YTD loss of 19.8% is nearly equivalent, even though it contains a more significant portion of low-quality companies. Overall, small caps have been resilient as the Bear growls, and, hopefully, that’s a good sign they could again be the leaders once the Bull takes charge.

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The stock market rally from the June low failed to break through its 200-day moving average on August 16th, and the S&P 500 has since fallen on tough times. The market advance was seemingly clipped, and the Bears again ruled! The decline began during the preamble leading up to Jackson Hole, and the S&P 500 completely collapsed after Chairman Powell’s hawkish speech reiterated the Fed’s resolve to bring inflation under control. The index dropped by about 9% from its recent high and is more than 18% below its all-time high.

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The contemporary economic and financial market cycle has been a weird one. It began with the biggest post-war bust in both real GDP and employment, followed almost instantaneously by a boom! It has been characterized by unprecedented use of monetary and fiscal stimulus, the lowest bond yields ever recorded in U.S. history, chronic supply-side shortages, the highest inflation in 40 years, and one of the speediest and most aggressive Fed tightening cycles

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With inflation still ravaging the U.S. economy and the leader of the Federal Reserve about to take center stage to inform everyone what he will do about it, investors should remind themselves that “disinflation” probably still rules. Yeah, you read that right.

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It’s yet another Fed week. Monetary officials meet in picturesque Jackson Hole, Wyoming, for some scary talk about fighting inflation, hard-line commitments to raise interest rates, and frightening possibilities about an imminent recession. 

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As inflation rages and real economic growth decelerates, investors share legitimate concerns about the direction of company earnings. Undoubtedly, profit growth will slow; businesses are simultaneously dealing with declining unit sales and margin pressures. In the coming year, the question is, will corporate earnings significantly collapse or simply moderate to a sluggish (but still positive) growth rate? That is, are profits poised to “Poof” or “Purr?”

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Who’s correct? The Federal Reserve is talking tough on inflation, indicating its fight is far from over and multiple rate hikes are yet forthcoming. The bond market, though, has turned decidedly dovish: The 10-year Treasury yield peaked in mid-June near 3.5% and has subsequently eased by about 75 bps. Moreover, the one-year breakeven rate (the bond market’s embedded one-year-forward inflation expectation) collapsed from 6.3% in March to 3.0% today. Indeed, the recent decline suggests the inflation outlook could soon be back near the Fed’s 2% target.

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An early mentor told me, “When your management style starts to reduce productivity, apply less management!” Fiscal authorities should consider that advice.

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Not all sectors are created equal. Some influence the direction and thrust of the stock market more than others. The Technology sector, however, has historically had an unparalleled impact on the overall performance of U.S. stocks.

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One of the problems with the bear market this year is there have simply been too many investors playing defense. Well, that has finally changed. Investors are again on OFFENSE, perhaps giving the stock market its best chance, yet, to ultimately put the bear to bed.

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The goal of decelerating real economic growth (demand destruction) has been achieved. The economy is not likely in a recession because job creation rose at an annual pace of nearly 3.7% in the first half of this year, real personal consumption increased by 1% in the second quarter, the ISM Manufacturing Survey is at 52.8, and profits, dividends, and capital-goods orders continue rising.

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Sometimes, trends get so extreme that it is best to bet on a reversal. Such is the case for a few critical factors underlying the health of the U.S. stock market. Because they have been stretched to exaggerated positions, there are currently three favorable forces for the stock market: real liquidity growth, private sector confidence, and valuations.

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Tomorrow’s meeting conclusion will be the “lucky 13th” since the start of 2021. Count me skeptical, but what is the rationale for having these glitzy Fed Pressers? Do we really ever learn anything on "Fed Day" that we didn’t know before the event started? 

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Here are a few morsels to start the week...

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VOLATILITY has wreaked havoc in the financial markets this year. The median stock-market CBOE VIX Volatility Index^® is 26.7 compared to only 18.6 in 2021 and is higher than 86% of the time since 1990. Because Treasury yields recently returned to some sense of normalcy, bond market volatility has also been challenging. For example, the median ICE MOVE Index (a yield-curve-weighted index of implied Treasury-option volatility) is at 111 versus just 61 in 2021—this is higher than 80% of the time measured back to 1990!

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After a promising start, year-to-date, international stocks are now trailing the S&P 500. At mid-year, despite a strong U.S. dollar, the MSCI ACWI ex-USA and MSCI EM ex-China indexes essentially matched the S&P 500. Indeed, through June, the developed markets index was ahead of the S&P 500 nearly two-thirds of the time, while EM ex-China surpassed the S&P 500 more than 90% of the time. Recently, as global recession fears have intensified and the U.S. dollar has soared, both international indexes now slightly trail domestic stocks. Nonetheless, we are sticking with a tilt toward global stocks—particularly EM ex-China—primarily because we expect the U.S. dollar to soon dive!

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Despite an obvious slowdown in real economic growth this year, and insatiable talk of recession, it is curious that S&P 500 EPS estimates continue to climb.

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The Federal Reserve has regular meetings and fancy press conferences, but like the rest of us, it is usually directed by its boss. The Fed’s board of directors comprises the character of the economy, both inflation and real economic growth, and bond vigilantes. This group of bosses primarily dictates whether the Fed is a hawk or a dove.

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Recession mania has gripped Wall Street: Surveys consistently show a high percentage of respondents expect that a recession is inevitable. That is true for investors, company leaders, and consumers. These fears are understandable because fighting against rapid inflation often ends in recession.

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