Paulsen's Perspective

VIX® is the popular name for the Chicago Board Options Exchange CBOE Volatility Index®. It measures the stock market’s expectation of future volatility based on S&P 500 index options. When investors expect more instability, they perceive greater risk, and for that reason, the VIX is often referred to as the market’s “fear gauge.”

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Theoretically, there is a supply and a demand, and they are brought together only by price. Obviously, both are important because when they get drastically out of whack, inflation rises or falls—or deflation develops. For this reason, it’s useful to separately monitor their developments in real-time. To fully appreciate the underlying source of inflation, one needs to acknowledge the status of “both” supply and demand. It could be too much demand or too little supply. Often, it’s a bit of both.

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Bond yields across the curve have been exceeding the speed limit lately, zooming toward an unknown higher equilibrium. Since year-end, the 10-year Treasury yield has climbed from 1.5% to 2.6%; it has surged from 1.75% just since the end of February! With the Federal Reserve now joining bond vigilantes with their own “pedal-to-the-metal” toward monetary tightening, who knows how “fast” yields might continue to advance? For investors, this begs the question, “Does SPEED Kill… Stocks?” Although yield levels are still fairly low, if they rise fast enough, can equities withstand such a monetary shock?

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Consistent with other sentiment measures, U.S. consumers’ outlook for the stock market darkened considerably in March. Chart 1 illustrates a segment of the Conference Board’s monthly consumer survey aimed at the stock market: the percent of bullish consumers less the percent who are bearish.

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As usual, this Friday’s employment report has plenty of intriguing plot lines. Could job creation surprisingly slow down just as recession fears are rising? Will another red-hot wage number add to inflationary woes? Could the unemployment rate really fall to the “mid-3s?” And what will all this mean for the Federal Reserve’s next meeting?

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Economic excesses often create potential investment opportunities. When a key economic factor reaches a ridiculous level, it frequently proves profitable to expect a reversal: Recall the 10-year bond yield at 0.5% in mid-2020 (those who tilted investment bets toward rising-yield beneficiaries have since profited)—or the early-1981 extreme of 16%? Another example was 1995, when the U.S. dollar spiked to levels never seen before—nor since. In the 1990s, the labor participation rate peaked near 68% after having never risen above 60% prior to 1970. And, in the mid-1990s, following a decline of nearly 20% from its 1973 post-war high, the real-wage rate finally bottomed.

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Putin’s war continues to create horrific human suffering and geopolitical turmoil, and the Federal Reserve has finally begun to raise interest rates as board members have quickly turned universally hawkish. As a result, the stock market has been volatile as traders assess whether correction lows have been successfully re-tested or if recent action is just a dead-cat bounce.

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A barrage of reports suggests Main Street is being ravished by runaway inflation. Individuals are struggling to buy enough gas to get to work and to put food on the table. Companies can’t find workers or supplies, and higher resource costs are threatening profit margins. Consumer price inflation is now at its highest level in over 40 years, and media pundits, politicians, policy officials, titans of industry, and everyday consumers believe we are seeing a replay of the 1970s.

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One way to judge if the stock-market correction is nearing its end is to look at how much “offense” has been hit relative to “defense.” Once aggressive investors have been adequately punished for their greedy overreach compared to the performance of more responsible investors, the correction has often run its course.

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There is no historical precedent for the Fed’s balance sheet of nearly $9 trillion! Moreover, the current level of the M2 money supply—relative to nominal GDP—peaked near 95% in 2020 and is still close to 90%. By comparison, this ratio averaged 55% from 1950-2009 and, prior to 2020, was never above 73%.

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Despite all the weirdness associated with the contemporary economic expansion and its corollary bull market, the current stock-market correction is right on schedule and looks remarkably normal.

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The contemporary bull market is widely perceived to be driven primarily by FOMO attitudes. Ostensibly, investors—wary of missing out on further market advances—have piled into stocks despite record-high valuations and, without much consideration, have been quick to buy any dips along the way. The impression is the foundation underlying today’s stock market are investors who have ignored risks, thrown caution to the wind, and stretched themselves to financial vulnerability by letting excessive greed rule their investment decisions.

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While supply-side activity is not necessarily a good short-term predictor for stocks, it does provide investors with a “central tendency” that the stock market has been inclined to mirror over time. For this reason, it is worth considering where the supply/demand spending ratio may be headed in the next several years and whether it will be supportive of stock prices?

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Due to recent, rapid wage gains, the prospect of a developing wage-price spiral has exacerbated concerns that the Federal Reserve is significantly behind the curve with fighting inflation. As shown in Chart 1, the Atlanta Fed Wage Growth Tracker has surged from 3% last May to 5.1% in January. That is substantially above its 3% to 4% average range in recent years and marks its highest annual increase in 20 years! Such a swift and large rise in wage inflation is alarming because it will almost assuredly force businesses to boost prices, which, in turn, could force workers to demand even higher wages. Ergo, this chart highlights that a wage-price spiral may already be in force.

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This economic recovery has been odd from the get-go! It started with the biggest bust since the Great Depression, followed almost immediately by one of the biggest post-war booms ushered in by the weirdest, and most outsized monetary and fiscal policies ever employed. Throughout, this expansion has occurred in the shadow of a horrific pandemic, producing an ongoing death count, widespread social separation, mask-wearing, vaccinations, and considerable political strife.

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Inflation is front and center in the minds of investors. It’s enemy #1! Not only has inflation soared to heights not seen in 40 years, but both monetary- and fiscal-policy officials show little concern. Neither has yet to officially “act” to aggressively restrict unprecedented economic stimulus. Although the Federal Reserve is now promising to tighten soon, its balance sheet continues to grow, and it still hasn’t raised the fed funds rate. Similarly, despite surging inflation reports, congressional leadership and the president seem disappointed they cannot pass even more meaningful spending legislation.

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Worries swirling around the Federal Reserve have gone ballistic. On Wall Street, there is a competition to see who can forecast the most fed funds-rate hikes this year. Expectations about the number of rate hikes in 2022 keep climbing—from three to as many as seven!

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As always, this Friday’s employment report will be closely scrutinized. Has the Omicron variant slowed job creation? Could the unemployment rate rise back to 4%? Will the “quit rate” remain high?

Chief among the concerns will be how quickly wages increase and whether any of the “lost labor supply”—the U.S. labor force is still 2.3 million workers fewer than at its December 2019 peak—finally comes back to work? With job openings currently almost 70% higher than the number of unemployed, an unresponsive labor force and surging wage costs weigh heavily on the minds of both the Federal Reserve and investors.

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The S&P 500 Index has ushered in the new year with its first correction of this bull market. The intra-day swings have been breathtaking, and some key segments are now in bear market territory. Who knows how long the carnage associated with this roller-coaster ride will continue and where the stock market will ultimately bottom? Encouragingly, though, first responders are already on the scene doing triage, which should soon stop the bleeding. It’s actually a “Triage Trilogy!”

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The U.S. U-3 unemployment rate is currently 3.9%, lower than 89% of the time since 1950. But the average duration of those unemployed is 28.6 weeks—longer than 91% of the time since 1950! Monthly job gains have been on fire, rising by an average of 537k during the last year. Nonetheless, the total number of jobs is still almost three million less (-1.8%) than the pre-pandemic employment peak in February 2020. Job openings have never been higher, and wages are supposedly surging (or is the wage rate overstated from a loss of lower-wage service jobs?). Yet almost 2.4 million people in the labor force cannot be enticed back.

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