James Paulsen: Investment Outlook (November 2011)

The Next Investment Catalyst?
Accelerating Economic Growth??

by James Paulsen, Chief Investment Strategist, Wells Capital Management (Wells Fargo)
November 2011

At least for the time being, the stock market seems to have survived yet another round of “Euro-Crisis Mania.” Recent policy actions announced yesterday by European officials have at least temporarily calmed fears of an imminent calamity. Most believe the rally in the S&P 500 Index to almost 1300 in the last month is due almost entirely to improvements in the European crisis outlook. While recent European developments certainly helped improve the mood of investors, we believe the recent stock market rally mostly reflects a huge reassessment of the potential recession risk in the U.S. economy.

The stock market collapsed in early August after a significant downward revision to real GDP growth in late July suggesting the pace of economic growth nearly flat lined in the first half of this year. Thereafter, the probabilities economists placed on an imminent U.S. recession rose significantly, and many prominent forecasters suggested a recession was indeed forthcoming. In recent weeks, however, a steady stream of “better-than-feared” timely economic reports from Main Street USA has calmed fears of an imminent recession. In combination with another robust corporate earnings season (which looks anything but recessionary) and capped by yesterday’s report that U.S. third quarter real GDP growth was a much stronger-than-anticipated 2.5 percent (with a robust and totally surprising real final demand growth of 3.6 percent!) has ultimately elevated investor greed beyond diminishing recession fears.

So now what? Investors have backed away from the recession cliff and the S&P 500 has returned to its approximate 1250 to 1350 trading range evident prior to the recession scare between February and July. Does the stock market remain trendless next year? Will it again come under intense selling pressure? Or is there a catalyst (beyond the notable currently attractive stock market valuation—that is, the stock market has trended sideways this year while earnings have continued to rise and competitive bond yields have declined) which would allow the stock market break out to new recovery highs?

Is Economic Growth Accelerating?

Although most have backed away from an imminent recession expectation, the consensus forecast still calls for only “muddling along” economic growth during the coming year. According to Bloomberg, the consensus economic forecast for real GDP growth is an anemic 2 percent for both the fourth quarter of this year and for all of 2012. Most believe the U.S. economy is destined for “sluggishness” since policy officials can no longer assist. Monetary officials are widely perceived as out of bullets and fiscal authorities seem helplessly gridlocked. Without another dose of stimulus, why should the economy improve?

Although policy official assistance for the economy may be limited, the private sector has adopted a policy of “self-medication” which could produce a surprising acceleration in real GDP growth next year. Exhibit 1 illustrates six sources of “stimulus” implemented in recent months which should improve economic prospects in the coming year.

Exhibit 1: Economic Self-Medication

First, the national average mortgage interest rate has declined by more than 1 percent since early this year. Long-term interest rates have declined by similar amounts on Treasury securities and on corporate and municipal bond yields. Although no policy official is responsible, long-term credit costs for many economic sectors have been significantly reduced in the last several months.