James Paulsen: Investment Outlook (February 24, 2015)

The KL Ratio is Rising ... But Will Productivity Follow?

by James Paulsen, Chief Investment Strategist, Wells Capital Management

After languishing in a sideways range for almost 15 years in the aftermath of the late 1990s tech bubble, a proxy for the U.S. capital to labor ratio (KL) recently rose to a new all-time record high. Throughout postwar history, changes in the KL ratio have been closely associated with the relative total return performance of stocks compared to bonds. Indeed, since the U.S. KL ratio flatlined after the internet bubble, the stock market has experienced its largest and longest postwar era of underperformance relative to U.S. bonds.

The U.S. KL ratio appears to be in the early stages of another significant advance. U.S. corporations have considerable cash reserves and pent-up demands to drive a capital spending cycle while the supply of labor is increasingly being restrained by aging demographics. If the KL ratio does continue to rise, stock returns should persistently outpace bond returns. The question is whether this will be mainly due to good returns from the stock market or bad returns from bonds? The answer will likely depend on the performance of U.S. productivity during the balance of this recovery.

The KL ratio and the stock-bond ratio

Exhibit 1 overlays the relative total return performance of U.S. stocks compared to long-term U.S. government bonds since 1950 with the U.S. KL ratio. The KL ratio is estimated by a ratio of U.S. industrial capacity and the U.S. labor force. Whenever the U.S. labor supply enjoys additional industrial capacity (i.e., more capital), equity owners tend to benefi t relative to debt owners. Most likely, this is because when labor is given more capital, it boosts productivity and augments corporate earnings potential.

The stock market has enjoyed two golden eras since 1950 (between 1950 and 1970 and again during the late 1990s) when returns solidly outpaced bonds and both were associated with a persistently rising KL ratio. Conversely, both periods when stocks either underperformed or only managed to match debt returns (i.e., 1970 to 1995 and again since 2000) were when the KL ratio faltered. The current bull market began in March 2009 and the KL ratio has been rising since the beginning of 2010. The KL ratio just reached an all-time record high. Does this suggest the relative performance of stocks will likely surpass its previous record high before the current recovery ends?

Exhibit 1: Relative stock-bond return performance versus capital-labor ratio*

Left scaleā€”Relative total returns, U.S. large-cap stocks versus longterm U.S. government bonds (solid)** Right scaleā€”Total U.S. capacity index divided by U.S. labor force (dotted)*** *Both series shown on a natural log scale **Source: Ibbotson and Bloomberg ***Capacity index is U.S. manufacturing index until 1967 and total industry thereafter

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