Kehong Wen's  Instablog

The new year has brought about a pervasive bearish tone on the stock market and among commentators. So it's rather refreshing to read Barron's interview with an informed optimist, James Paulsen, the Chief Strategist of Wells Capital Management.

A warning is in order. Many of these economists and strategists, once have taken a position, will be hard pressed to change their perspectives. Because they've built up a vested interest in that view, they often have to defend it, over and over again. Another reason for doing so is, if you change your view too often, the listeners get confused and get lost. The ability to sort through many of these rather conflicting views and opinions can be crucial for investment decisions. This ability is something we have come to define as "Interpretation Quotient" at IQR.

With that in mind, let us see what Mr.Paulsen has to say about the US economic recovery.

After noting the pervasiveness and the support for the pessimism in our conventional wisdom, Mr.Paulsen comes to the first substantive statement about why corporations will have a leading role to play in this recovery: "Companies have the greatest profit leverage that they've had in decades. Right now, the level of cash flow relative to capital spending on corporate balance sheets is at a 50-year high."

Couple that with the fact that there is more than $1 trillion of cash sitting on corporations balance sheet, and the favorable financing condition, we can see why companies are ready to charge ahead.

Next logical question is then why would companies increase their production and hiring, if demand for their products are not there? This is of course one of the main arguments in many pessimists' views, that the consumer's psychic has been seared forever by the devastating financial crisis which has knocked down his wealth and income somewhat permanently through home value decrease, 401k erosion, restrictive borrowing and unemployment. Given that 70% of the US GDP is US consumption, the conventional wisdom has it that we'll see at best sub-par growth for the years to come.

To this question, Mr. Paulsen comes to the second substantive statement: "Household-debt levels remain a problem. But I think the issue has been overdramatized. During the bust, the biggest problem wasn't so much the people who lost their jobs as unemployment surged from 5% to 10%; it was the other 90% of the folks who had a job but were scared out of their wits. They just quit spending. Now, however, their paralysis is abating."

He goes on to observe some tentative signs why US consumers are likely to return to the mall, more so than expected. Add to that the contributions from inventory rebuild, stabilization of the housing and auto industries, government spending, and export growth, he makes his case that we could see real GDP growth at above 5% level for 2010. That's 1-2% more than many expect. Greater growth bodes well for the stock market.

Additionally, the demand for risk assets are likely to increase gradually, because "Liquid-asset holdings of households and businesses now stand at around $10 trillion. That's a record, relative to GDP. This money is likely to act as a slow-release Tylenol tablet over the next several years, leeching into the market and driving stock prices higher." 

That's the third substantive statement.

The mother of all challenges facing the US is the huge budget deficits hanging over our heads. To that Mr. Paulsen makes his fourth, rather surprising statement: "I don't think we're in an Armageddon situation. We've run large deficits as a percentage of GDP in the past, such as in 1975, when the deficit blew out to 6.5% of GDP and people thought the world had come an end. If you look back in U.S. economic history, the five years after the deficit peaks invariably have torrid growth. Same for the peak in unemployment, which we recently hit. Remeber: President Clinton left us in the late 1990s with budget surpluses and low unemployment, yet the succeeding decade was nothing to write home about in terms of either growth or stock-market performance." 

That is a powerful contrarian argument.

It will be most interesting to analyze these arguments alongside PIMCO's thesis of the New Normal, that we're entering a post-crisis era of slow-growth because of de-leveraging, re-regulation and de-globalization.


Disclosure: No position

After the surge in the first week, the markets have been going down for three consecutive weeks. The best performing sectors (material, energy, technology) have turned into the worst performing ones. Is this a start of a new (down) trend? Or merely a necessary correction?

We think it's just a correction. The three sectors that have been performing well in 2009 are all tightly linked to global demands, especially in emerging markets such as China. China's extraordinary stimulus policies have largely avoided a slump that was widely believed to follow the financial crisis. But the result came with a big price: China is risking an over-heated real estate market reaching the bubble territory. The government, being an effective and anticipating manager of the economy, is trying to slow it down a bit before inflation breaks out. This has created concerns that this engine of global recovery may be running out of steam.

China is not going to slow down dramatically. It cannot afford to. It needs sufficient growth to provide employment. A small slowdown is good for the transition to a more balanced growth path, one that depends more on domestic consumption than export.

In the US, there are signs that the economy has started its slow recovery. The housing market has most likely reached some sort of bottom in parts of the country. Consumption has started to contribute to the GDP growth (4Q). US dollar may be on a new trend of strengthening, at least relative to Euro and other developed currencies. Commodities and energy may thus lose a strong support. Yet, we doubt this is going to last very long. The US recovery is still very weak. Mind-boggling national deficits will need more supports from the Fed. Consumers are still working through their debts. US will need all the helps it can get, including a weak dollar to help stimulate exports.

Emerging markets, which are fiscally much healthier than the US, should continue to grow more rapidly. We expect energy, material, and tech sectors to continue their relatively strong performance into 2010.

Disclosure: No positions

Disclosure: Long Global Recovery

Disclosure: Long WFC, JPM