Episode #356: Jim Paulsen, The Leuthold Group, “The Wildcard Is Inflation and Whether It’s Truly Transitory”
Guest: Jim Paulsen is Chief Investment Strategist of The Leuthold Group, LLC. He is a member of the investment committee, authors market and economic commentary, and works with the Leuthold investment team in serving institutional, financial advisor, and investment professional clients.
Date Recorded: 9/22/2021 | Run-Time: 48:49
Summary: In today’s episode, we’re talking markets with someone who’s been at it for over 30 years. Jim explains why the shift from a depressionary bust to a boom last year was unlike anything he’s seen. Then we talk about where current sentiment is and how investors are positioned. Finally, Jim walks through his framework for analyzing whether inflation is truly transitory and what he expects to happen as the Fed continues to taper.
Be sure to stick around and hear where Jim thinks you should and shouldn’t be invested if we experience a market pullback.
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Links from the Episode:
- 0:40 – Intro
- 1:16 – Welcome to our guest, Jim Paulsen
- 1:57 – What the US economy looks like to Jim today
- 14:04 – Why investor fear and market returns aren’t aligned lately
- 15:31 – Healthy balance sheets, emerging startups, and productivity growth
- 21:07 – Growing public concern about where or not the Fed will start tapering
- 24:09 – Let’s Talk DEFENSE (Paulsen); His thoughts on rebalancing defensively for a possible market correction
- 27:09 – The strangeness of sovereign bonds and interest rates around the world
- 33:09 – Is gold still both a hedge against inflation and store of value?
- 38:56 – Jim’s favorite charts and indicators
- 42:04 – One of the most memorable moments of his career
- 44:02 – Would alien discovery be bullish or bearish for markets?
- 45:30 – Learn more about Jim Paulsen; leutholdgroup.com
Transcript of Episode 356:
Welcome Message: Welcome to the Meb Faber show, where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing, and uncover new and profitable ideas, all to help you grow wealthier and wiser. Better investing starts here.
Disclaimer: Meb Faber is the co-founder and Chief Investment Officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions, and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
Meb: What’s up, everybody? Today we got a great show. Our guest is the chief investment strategist at The Leuthold Group, an independent investment research firm. In today’s show, we’re talking about markets with somebody that’s been doing it for over three decades. Our guest explains why the shift from a depressionary bust to a boom last year was unlike anything he’s seen.
Then we talk about where current sentiment is, and how investors are positioned. Finally, he walks through his framework for analyzing whether inflation is transitory, and what he expects to happen as the Fed continues to taper. Be sure to stick around and hear what our guests think you should and shouldn’t be invested in if we experience a market pullback. Please enjoy this episode with The Leuthold Group’s Jim Paulsen. Jim, welcome to the show.
Jim: Thanks for having me today.
Meb: Live from Minneapolis. Listeners have heard this story, but you haven’t. Last time I was there, I had just arrived in Minneapolis for the National Championship Basketball Tournament, a few years ago, and I was walking down the street by myself. This is close to downtown, by the way. And, the first thing that crossed me on the sidewalk was a turkey. And I looked around and I said, “That can’t be a turkey. Is that a chicken? That’s a turkey, just wandering around in the middle of downtown Minneapolis.”
Jim: Those turkeys are ugly creatures, man. They’re big and ugly.
Meb: He took one look at me, got out of the way, walked across the street, and that was that. I loved it. Great town. So, you put out a ton of awesome content, and I get a daily email with one of your charts and missives. This has sort of been, I feel like the last year, almost, and I’m trying to say this in a thoughtful way, excluding all the death and destruction, everything else, kind of like an amazing time to be an economist.
There are so many things going on. And it’s almost like a lab for what’s going on in the world. And here we are, 2021, hopefully coming out of it. Let’s get started, and we’ll just start broad. What’s the world look like you today? And we start with the U.S. economy, seems to be rocking and rolling. My local Mexican joint seems to get more and more expensive with the margaritas.
Jim: Meb, I agree with you. There’s so much that’s out of bounds today, so to speak. But, you know, I’ve been in the business since 1983, and I swear, I’ve been through all kinds of out-of-bounds episodes, even when I started, with the double-digit interest rates, and no one had ever seen, we came off the fat, the biggest decade of inflation ever in our history, and everything’s been a first ever since. So, in some regard, as weird as this environment is today, it’s not that much different than it’s been for much of U.S. history, where everything is kind of the first that the…and I think every generation had that same kind of feel.
I guess when I look at things today, to me, two big things that played into the post-pandemic sort of situation. One is that what the pandemic did from an economic standpoint, that’s probably the most significant, and not, like you said, leave the health thing of it for a minute, just the economic standpoint, is that it put the world economic cycle on the biggest bust-to-boom cycle almost ever, in the world history, at least in post-war history in the United States, if not U.S. history, in that we went down by about, year-on-year, by 10%-plus in 2020, which was the biggest drop in real GDP year-on-year in post-war history. And then, within less than a year, we’re back up over 12% year-on-year, which is almost the fastest rate of growth in post-war history. Now, what makes that particularly interesting is that we basically had all the players and policy officials around this, a deal with what was essentially at the moment thought to be a depressionary bust, that no one knew if it ever was going to end because the health crisis. We had no sense of it. We closed the economy by pronouncement.
It wasn’t because of recession. We just declared a close. No one had ever seen anything like this, and we didn’t know how long it was going to last. It was the fearful situation. And then, within a matter of months, we gave everybody a post-war boom. And going from a depressionary bust to a post-war boom created a lot of different things. One big thing is it created a lot of panic. And so, I think some of the outsize policies we have from around the globe are the result of policy officials just purely panicking with what they were facing. And just saying, “We’re going to dump everything we got and we’ll look at it later.”
But, it affected every, all players. It affected consumers, who received massive amounts of liquidity and stimulus checks, and they hoarded most of it, because they were scared to death, at least initially. And so, we had massive savings rates, and unspent future demand power sitting on the sidelines for a period of time. And it created, it put expectations on the biggest whiplash ever, where you think about Wall Street facing a depressionary bust, and having their expectations do that. And then, within a matter of months, all of a sudden, biggest boom ever, and they couldn’t catch up.
And what it did to companies that I think is the most significant, companies normally start to pick up a recession, they start to get a little more conservative, and, you know, reduce activities a little bit, pare back debts, they do, to try to live through a downturn. And then, takes off, where they realize they’re in a recession, and then they get a little more conservative. Now, that’s not what happened here.
When we made the proclamation we’re going to shut it down, they instantly went to how to survive a pandemic, not how to get through a recession. And so, they created the biggest drop ever in real GDP, the biggest job loss ever, the biggest inventory drawdown. And essentially, all of corporate businesses across the globe went to their most efficient operating spot, minimum cost to keep a business operating, most efficient spot.
And then you give them a post-war boom, you’re going to have an unprecedented profit cycle as a result of that. It wouldn’t have happened had we not had everyone prepare for a pandemic, to get to the other side of the pandemic. But because of that, we put them in the most efficient position and then gave them a wartime boom. To me, that’s one big thing that’s happened. The other big thing that kind of dovetails with that is policy officials have just decided to try something new.
In the last 20 years in this country, we’ve had the slowest real GDP growth rate, the average annualized slowest growth rate ever, outside of the Great Depression. For years, that’s been disappointingly lower, and lower, and lower. The last recovery that we had, from ’09 to ’20, it grew just a little over 2%, which we used to call the “stall speed of a recovery,” we persisted at that, throughout.
And I think policy officials said, you know, we’ve been doing this forever, quick to tighten, quick to worry about inflation, ever since the 1970s, and it just isn’t working. Growth is slowing, inequality’s spreading. And so, they decided to run it hot. And that’s what they’re doing. What I mean by running hot is they’re running the growth rate, nominal growth rate in the country, above the long-term cost of capital, or rate structure, the 10-year yield.
Now, we’ve done this before. We did it from 1950 to 1980. The first 15 years, 1950 to 1965, it was an absolute, massive success. Running it hot, that is, keeping the growth rate always above the rate structure, led to a situation where we had really solid economic growth, fabulous productivity, great job creation, more times than not, a wonderful stock market. It was interrupted by recessions. And we did not get inflation, and we had kept a low rate structure.
The second period was ’65 to ’80, where we had run…the same policy resulted in runaway inflation and, of course, the highest rates and inflation ever in history. So, here we got two examples of how to run hot. Ever since 1980, we’ve run it cold. We have chronically run real nominal GDP below the rate structure, most of the time since 1980. And now we’re opposite that. And the question’s going to be, are we going to get the ’50 to ’65 golden era of capitalism, or are we going to get the ’65 to ’80? And that’s the debate that’s still going on.
My druthers on that is that we’re going to get some leftover higher inflation here, as a result of running it hot. But it’s not going to be runaway. I think maybe we move inflation up from an average of two-ish to an average of three-ish, eventually. That a lot of this inflation problem, in the short term, is indeed due to the bust to boom cycle we put the economy on, where supply just can’t catch up. That will eventually catch it up.
But what I’m most excited about, and this gets to the markets, is that I think there’s things that have happened post-pandemic here that are going to leave a sustainable mark on the economy, to have it grow faster than it has for decades. Not the result of policy, necessarily. In other words, once we hit both the monetary and fiscal cliffs, which are coming fairly soon, they’re just going to fall out. We have one more fiscal juicer and then that’s probably done, and monetary’s already starting to turn. Those are negative forces.
But, other things have happened to leave a lot of positive … growth. And so, I think this recovery is likely to last several more years, and is likely to grow more like three and a quarter, three and a half, rather than two and a quarter, two and a half. That is a huge difference, and we’ll feel… So, of those things, we look at what has resulted in the possibility to grow faster. And I’ll just throw out a bunch of things that I see.
One is pent-up demands, which have not just started once the pandemic started, they’ve been building ever since, at least the Great Financial Crisis, in ’08. If I look at durable goods as a percent of consumption, percent of GDP, they’re a full percent lower than where they average most of the time in post-war history, and are just now turning the corner in the last decade. If you give people the wherewithal, there’s a lot of room to catch up, is my point.
And then, we have, I think, a lot new job holders that are going to come to this market on a delayed fashion, compared to most recoveries. So, here, we’re in, year and a half, maybe two years into a new recovery, and we’re yet to get this big slog of workers returning to the labor force yet, which that means they’re going to come next year, the year after, whatever, adding to growth in a way that isn’t normal at this point in the cycle, so to speak.
And I’m talking about, because of the particulars of COVID, making childcare more important till schools are operational, and that might even take more until next year before it starts to happen there, with Delta, for example, in kids under 5 and 12 not yet vaccinated. And then also, because we overdid the unemployment benefits, we’ve kept people on the sidelines, and that’s going to change. So we’re going to have this added juicer with job creation.
I also think that we have something that we have done in the past recoveries a little bit, when the unemployment rate’s fallen to around 5% or so, we start to get an increase in the labor force participation rate. We might not recover all the way back to where we were 15 years ago, but I do think we might get close to where we were pre-pandemic. And if we do, if I put that into the mix, right now, even though we got a 5.2% unemployment rate, or wherever it’s at, the effective unemployment rate is closer to 7.5%. So we have a lot of capacity there left, if that does come through. That means you can grow fast, and absorb. We also have a lot of room to increase confidence yet in this recovery. There are some measures, like the University of Michigan Consumer Confidence Index, which is still lower now, supposedly, than it was at the bottom of the pandemic, in early ’20. Other ones show a better result.
Meb: Why is that, by the way? Is that just a artifact, or just these CEOs are grumpy?
Jim: One of the things it did, Meb, was it really did elevate all of our fears. And we still have a fair number of fears. I personally see, just behaviorally, things like $4.5 trillion of cash balances being held today in money market mutual funds, which, generally, you see the peaks of those money funds associated with market bottoms. We’re seeing it, after a market high, we’re seeing $17 to $18 trillion of deposits available out there.
You’re seeing the ratio of high beta to low vol investing still close to almost its lowest level since 1990, rather than the high levels of anything we saw, like, for example, in 2000, overall. We’re seeing a continuous flow into bond mutual funds, and some flow now into equity mutual funds, but a lot more still going to bonds. This, to me, it just is an example of defensive, kind of conservative behaviors that exist in part because of the pandemic. When you look at, historically, when confidence is low, future stock returns are high, because there’s room to improve.
Just like when there’s slack in the job market, future return potential’s high. So I see a fair amount of slack. We’ve also had two really nice things. One is the boom in household formations, which are generally driven by millennials. And, they’ve finally decided to get married and form households. And what the next thing they’re going to do is go into their peak spending years, when they start filling out those households and having, kids and it’s going to be like a mini baby boom, again, coming.
At the same time, inexplicably, and I don’t even understand this, per se, we’ve had a boom in new business formations. Maybe it’s tribute to the creativeness of capitalism, but while other companies are going out of business, we just have a boom of new biz forming, and those two together are dynamite for sustaining growth rates in the future.
Meb: You brought up a couple things that I found really interesting. The first being, you know, you talked about sentiment, and I love talking about, one of my favorite examples being the old American Association of Individual Investors, are you bullish, neutral, or bearish? And, like, December ’99 was the most bullish they ever were. And then, March 2009, was the most bearish they ever were. You couldn’t make it up.
Economists couldn’t craft a better ridiculous scenario. And I look at it about every month or so, just out of curiosity. It’s been pretty melancholy, despite the stock market hitting new highs. And usually, like, if you look at the quantitative studies on it, and y’all’s group at Leuthold has done a bunch here, when people are fearful, usually, the returns are high and vice versa. So I was looking at it recently, and it’s still not where I would think it would be where we are in the market. So, who knows.
Jim: I agree with you on that. You know, the AAII just fell to pretty close to its lows of the entire post-pandemic cycle. If you look at Conference Board’s bull less bears, they’ve come up, but they’ve, kind of like you said, been melancholy, and they’ve … returned too. It is interesting. People are still holding a lot of gold. The ratio of gold prices to the overall CRB index is still closer to a 50-year high. It’s off from its really big highs, but it’s still closer to that than its lowest since 1970. So, a lot of things, to me, are fairly conservative yet. And I think, you know, we got room to improve that and get more animal spirit behaviors in play yet before this recovery ends.
Meb: The business formation is an interesting topic, because I have an opinion here that I don’t think is widely held, where, over the past five, six, seven years, I’ve seen an explosion in really amazing startup companies. And whether that’s simply because software and the internet, and, in the last year, distributed workforces, like, it’s all coming together, whether it’s because you’ve had a lot of successful tech companies get liquidity, in which case, these guys then start funding the startups, or whether it’s the QSBS legislation, which gives startup funding of companies less than $50 million a big tax break, which, by the way, may be on the chopping block… I was ranting about this on Twitter, because I said, “My god, this was a policy approved under Obama, that the Democrats are now trying to kill,” that I said, at least I’ve said before on Twitter was, in my opinion, one of the most impactful pieces of legislation for business creation on the tech startup side in history, and now we’re trying to get rid of it.
Anyway, it could be some of those factors. I don’t know. But it’s a weird barbell dislocation for me, because as a quant, I look at stock market valuations, and I’m always Negative Nancy on that sort of part of the world. But then I look at these young startups, and it’s so optimistic and incredible to see all these companies started, every day.
Jim: There’s a part of me, Meb, that agrees a lot with what your sentiment and what you’re saying. In some ways, I’ve thought that we have euthanized ourselves, and I don’t mean kill our self, I mean made ourselves younger as a country, through technology. We’re the unadulterated leader of new-era innovation. And, in some sense, we have an older demographic, but just think about, from an economic standpoint, because we lead the world with technology, how much younger we are, our demographic is, even though it’s just as old as Europe and Japan.
Economically, we are so much younger … as a result of that. And it just doesn’t stop. The great bulk of innovation still comes out of here. Now, it’s also being driven a little bit by a younger demographic and millennials, next-gens, but technology itself, and continuing to be a leader in that area, I think, is a huge, huge benefit for the United States that’s going to continue to pay dividends.
But, at any rate, I just, real quick through some of these other ones. We know about the massive unspent savings that have been built up. Those won’t all come out in one year, and we obviously have to rebuild inventories here. And normally, we don’t have such a mismatch, where production has to catch up to supply, but we do. I think we’ve got incredibly healthy household balance sheets for the first time in decades.
The debt to income ratio for U.S. households is now the lowest it’s been since 1995. Debt service is even lower because of low rates. Net worth is just exploding to the upside. They’re chunk full of liquidity. They have incredible debt capacity, if we can ever convince them they want to do that again. That’s kind of like the 1950s, a little bit again. And then there are banks, which have incredible lending capacity, because nobody has been lending money for so long.
It’s kind of an interesting possibility there overall. The last big thing here is productivity. Obviously, it’s been up since the pandemic, with GDP back to new highs, where employment is still below previous peaks. We’re having quite a surge in productivity. But I think there’s good reason… I’ve written about this and shown, that if you go back to 1950, whenever tech stocks have a prolonged leadership cycle, that’s followed by a pickup in productivity, with about a trail of about three years. Well, we’ve just gone through arguably the second-largest tech cycle of our history, maybe the third. And I think it’s going to be followed by a sustained pickup in productivity, which could make a huge difference for growth.
So, to me, the biggest thing investors should think about is if we do grow three and a quarter rather than two and a quarter, in real GDP terms, and if you put inflation at three, but if you want to say it’s a little higher, we’re going to get back to the five and a half, six-ish area. That puts you back in old spirit capitalism, back in the good golden days. And I don’t know if we fully appreciate that yet, and what that means for stock investors overall. And I guess that’s where I’m at.
Now, the course, the wildcard’s inflation, and whether it is truly transitory. I think it is. I think we have a lot of disinflationary force yet in the world. We got lousy demographics in the developed world. China’s now got even worse demographics, supposedly the leader of the emerging world, which I think it’s falling out of bed on, but that’s going to hold growth down. We have a very much more open economy, for example, in the United States than we had in the 1970s. We’re much more globally competitive, which holds prices down. Our labor force growth is growing at best 1% a year. In the 1970s, it grew 2.5% a year. So, we’re not going to do that ever again. We got falling monetary velocity, is a chronic statement for decades now, as opposed to flat. We certainly don’t have the inflationary mindset that I did as a kid, where every day, every year, the new school pants went up, and so did car prices and everything else.
Today, back then, the leader was automobile industry, with sticker prices went up every year. Today, the leader’s tech, where sticker prices go down every year. So, I do think that those global forces will win out. And this is more of a bust-to-boom inflation cycle, but I think it’s going to have some leftover remnants, leaving inflation a little bit permanently higher, just not sort of runaway inflation overall.
Meb: It sounds like that would be a pretty awesome scenario if all this comes together. You know, a lot of people, particularly in the media, are hot and bothered about when and how’s the Fed going to do tapering, and what does that mean? And what are the implications? As an economist, I’m sure you have some opinions on that. Maybe tell our listeners, just in general, why this is something everyone’s so concerned with? And what is your general belief system on how that plays out?
Jim: Tapering, in a broader sense, is just a decline in the rate of monetary growth. And it is a long history of monetary growth rates leading, or coincidently leading the economic growth rate, and coincidentally, a lot of times with stock market performance. It’s not a perfect relationship by any stretch of the imagination. But it’s certainly been there, not just in recent years, but for decades, of course.
So, it’s always very concerning when you go from accommodative to a less accommodative to eventually a full-on tightening in not only monetary, but fiscal policy as well, perhaps. We’re going to face that. Now, the thing is to remember is we face that in every recovery, so this one’s no different. I would say this. Here’s what’s been interesting for me, and what I’ve written about, is both quantitative easing, the annual growth in that, and the annual growth in the M2 money supply, have already been tapering for months this year.
Both of those, year-on-year, peaked out in February. The quantitative easing peaked out at an annual growth rate of 80% year-on-year. It’s now under 20%. The M2 money supply peaked out at 27% year-on-year, and it’s now down to 12%. And my point is a big part of the “tapering” has already passed. There’s going to be a little more, but what’s left is a lot less ferocious than what’s already occurred. And you can say, well, it didn’t have any impact. Well, yeah, it did. It had a lot of impact.
I mean, remember, bond yields peaked right when tapering started, in early March, commodity prices stopped soaring and kind of been moving sideways since. Growth stocks came back into favor once tapering started, and cyclicals and small caps rolled over, in terms of leadership ever since. International markets quit outperforming. That is, there was a … defensive sectors have been market performers ever since tapering began.
So, there’s been a ton of impact from the tapering that’s already been in place. It just hasn’t caused a 10% correction to the S&P 500. But it’s done everything else you’d normally associate with tapering. I would argue at this point that this has been so well-advertised that this, to me, is a situation where you might want to sell on the rumor and buy on the news.
And by the time we officially start tapering, most of the actual tapering, I think, is already behind us. There’s been a lot of pain. We’ve had rotational leaderships, which people have noticed. But part of the reason for that is because we’ve had first, a monetary explosion, and then we had a tapering, which caused there to be shifting rotational leaderships already.
Meb: Well, you had a nice piece about defense recently, that you were, said, “Let’s talk D,” about a couple weeks ago. You want to walk us through your thesis there, where is that going to be a good place to hide or not in the coming months?
Jim: Three things on that. One is, certainly, if the market hits an air pocket, which, it’s going to happen sometime. We’re not going to ever not ever have a correction. I wouldn’t be shocked if we have one yet this year. And the real intense portion of those corrections, you know, Meb, when it really drops, usually a big chunk of it happens within a week or so. You know, that’s kind of how they happen, or a month.
And during that period, defense stocks will do fine. They’ll do just fine. But I’m not so sure, over the whole period of the correction, from the time it goes down, to the time it sort of flattens, to the time it comes back, that defense will outperform over that whole period. I think it’s going to have some problems. And the reason I say that is a couple things.
One is, when you look back historically all the way to 1950, when we’ve grown below 2.5% real GDP, defense generally outperforms, I can’t of the exact numbers, something like 4% a year or something like that. But when you grow more than 2.5% in real GDP terms, it underperforms, over 3% a year. And what we’ve gotten used, really, at least since 2000, we’ve gotten used to growing less than 2.5% a lot of the time during recoveries, whereas prior to that, the only time you’d do that, you were headed to a recession, when defense stocks would do great. Defensive stocks.
But now, we’ve had the expansions, which grow at two and a half. And, of course, that’s just like the perfect spot for defensive stocks. Really sluggish, disappointing growth, but it’s still an expansion, and defensive stocks have done really well. My point is, this time, even if the economy slows down, and we have a correction, we might have a correction while we’re growing 5% or 4.5% or 4% real GDP, which is probably going to be too fast for defensive stocks to really do as well as they have historically during corrections. And the other problem that I think they could have here is Delta. And we’ve never had a correction yet during COVID.
And there has been, I just published this this week, a very close relationship between case counts on COVID and what performs, not necessarily overall market, but whether defensive stocks outperform, growth stocks outperform, small-caps, cyclicals, just trace out that COVID cycle really close. So do bond yields. So do commodity prices.
And my point is, is that right now, we’re in a situation where if we have a correction while the Delta variant is peaking and coming back down again, okay, a correction would send you to defensive, but a drop in the COVID variant is going to send you to cyclicals and economically sensitive stocks. So, we could have a correction where defensive stocks don’t do near as well because it comes in the context of another re-opening cycle in the economy, due to a pullback in COVID.
Meb: As you mentioned earlier, being an economist for the past 50 years, it feels like weird is normal. We like to say that when it comes to actual financial market returns, normal market returns are extreme. You know, everyone expects, like, a 10%, but it’s not 10% a year. It’s, sometimes, it’s up 30%, down 20%, all over. And one of the weirdest parts, I think, for a lot of people this cycle, was wrapping their heads around interest rates, and seeing interest rates around the world go to zero and then just keep going.
There felt like a period last year where that might be on the table for U.S. interest rates. How do you think about where we stand with sovereign bonds, and corporates, too, if you want, around the world today? Is it something where it feels like they’re artificially low? I mean, granted, we’ve had, I don’t know, how many decades of Japan being an outlier there, too. And then, within the U.S., is that a world major asset class? Is it something you see…is it going to be totally dictated by inflation, or what?
Jim: I don’t know the answers, like I don’t know any of this stuff, Meb. And, I’ve been I’ve been in the business long enough to be wrong several times over, so, you know, just take my best guess at this stuff.
Meb: That’s the most thoughtful response you can have, by the way. Those of us who have been in markets long enough, you’re either have the humility and scars, or you are no longer involved in the markets anymore. There’s not a whole lot of in-between.
Jim: I tend to believe that the market… Bonds are being priced right where the market wants to price them today. I don’t really think they’re overly distorted by QE. And I don’t know if that’s right. I think the price where they should be…I’ll tell you what. Rates have been low in the past. They were pretty low in the ’50s. They were extremely low in the Great Depression, of course.
I’ll tell you what’s different about today versus those periods. The Depression contracted much further than we had here. But we’ve never really, as I said, we never had a period where we grew that slow, a little over 2%, for that long of a period of time. And it’s not just us. I mean, we had a bad experience, but Japan has been doing this for twice as long as we have. And Europe’s been, they’re maybe one and a half times as long as we have. When this started with Japan, there was only seven economies in the world that mattered, and one of them went down big time.
And then, another big chunk went down right after that. And then, we finally did. So, we’ve had really, 30, 40 years of incredibly sluggish growth, not ever before seen in U.S. history. We’ve had depressionary collapses, that then came back, but never a persistent … So, what does that do to rates? Well, I’m always been believed that rates don’t set necessarily for the given year environment. They’re affected heavily by what you’ve been through, just like so are stock prices and the like.
And I think a persistently sluggish growth environment like never seen before in its persistency has led to a rate structure in the world that’s got really low. The short rates were negative in the Great Depression. You know, bill rates went to premiums. And so, it’s not like it’s unprecedented overall. When you look back historically at the 10-year yield in the United States, for example, you will see that inflation, common in our history, was above the 10-year yield. That is not at all uncommon scenario.
Indeed, in the last decade almost, from 2012 to date, the 10-year treasury yield, since 2012 now, has been below the median CPI inflation rate in this country about 75% of the time. It is currently, but it’s not anything new post-pandemic. It’s been that way a lot of the time since then. And of course, so is Europe’s, and a lot of Japan’s. And so, I think this has more to do with some of these longer growth expectations birthing a whole culture that expects a certain growth rate than it does with quantitative easing.
For example, it is very clear to me that bonds had, the 10-year yield had no trouble moving from 0.5% to 1.75% while the Fed was doing $120 billion of QE every month, from roughly September of last year to February this year. Why, suddenly, in March, when the Fed didn’t change what it was doing at all, did it have any trouble going up? And so, I think it’s doing what it wants to do. I think a couple things affect it overall. And, ultimately, I think that in this cycle, if it lasts long enough, that bond yields will trade back above inflation again, at some point.
And if we run inflation around three-ish on the average, then I think bond yields will probably get in the three to four land before this recovery ends. If you don’t expect runaway inflation, I don’t necessarily see runaway bond yields. I don’t think the fact that we’re bottoming out the great bond bull of the last 40 years, which we are, probably, means that we’re got to go right back to the 1970s with bond yields.
I think a much more likely scenario is we come down and we just trade down here at low rate structures, kind of like we did after the depression, for quite a while, before they really went back up. That doesn’t mean they won’t go from maybe two-ish to four-ish, or, you know, get back in that range again, but I don’t know if they’re going to just surge back higher. And when you think about it in those terms, we’re not that far out of whack. Heck, we could be back close to 2% by the end of the year if COVID comes down, growth picks up, people get optimistic again, inflation fears come back, Fed starts to taper, all those things could bring us back into that range pretty fast.
What I would say about the bonds, high-quality bonds, right now, where they’re priced, to me, they are really on the verge of just being a non-viable asset. And what’s interesting is we all, I manage a … portfolio. We have 20% of minimum … in bonds … and yet I don’t know really why we’re buying them, because it just doesn’t make a lot of sense to me. Most investors should think long and hard about how much they have there, at least till they have to adjust.
Meb: One of the head-scratchers, I feel, for a lot of people that see what’s going on in markets, and they look at bond yields, they look at inflation, is, I feel like a lot of people assume this should be a shining moment for gold. And gold isn’t doing much this year. In fact, it seems to be sliding in the wrong direction, getting a little dusty. Are there any secular trends at play here? Is this an India-China story? Is it something that it just moved too far too fast, or are people just not interested, and they’re buying JPEGs and NFTs with money they would have bought with gold? Any general thoughts on the shiny metal?
Jim: Gold’s still, in my book, fairly elevated relative to commodity prices in general. It’s, as I mentioned, outside of 2020, when it shot way up, and now it’s come back down on a relative basis to other commodities, it’s still, even before 2020, it was close to a 50-year high, going back to 1970. So, it’s still up, and I think that is true. I think the biggest thing for gold is the same kind of thing for all defensive assets, Meb, of late, and that is to say, at the end of the day, when real GDP growth is 5% to 10%, and it’s forecasted next year maybe even being four and a half-ish or something yet, if that is the case, and profitability has recovered faster than almost ever before coming out of a cycle, and has gone on to record highs, and there’s more companies that continually outpace all, any Wall Street expectations on the upside, I think that just kills off the favorability of defensive assets in general. It isn’t just gold. Low vol, defensive sectors, cash, certainly, bonds, and not done real well, really, in the post-pandemic rush, if you will.
Meb: As you look around the world, what, that we have not talked about, has got you excited, concerns, confused, that’s just on your mind? What’s on your brain these days that we haven’t covered so far?
Jim: One of them is valuation, which, like to visit a little bit about, because I think it’s the biggest thing holding stock investors back. And it’s understandable. There are a couple things to be hit on that one. One is that we’re in a very different valuation range now since 1990, for 30 years running, than we were in in the previous 130 years prior, dating back to 1870. And people know that, but, I mean, we’re talking, if you took the Shiller CAPE multiple, we’ve been, I don’t have the exact numbers in front of me right now, Meb, but we’ve been, if you look at the entire 160-year history or whatever, in the last 30 years, we’ve been trading above the 80th percentile three-quarters of the time, something like that. It isn’t that it was dot com, and it was a short period, then we came back to normal. We’ve stayed at higher valuations really ever since 1990.
So, I think we are in a new range, at least till we’re not. And there’s a whole host of reasons for that, I think, that I could get into if you want to, that it could persist. And it’s not just low rates. But I do think that we’re in a new range. And then, if I look at that new range, what we’re seeing now, going all the way back, even to the ’80s, is that when we start recoveries, valuations typically are very high. Happened in ’82, happened in ’90, it happened in 2003, happened in 2009. And then what happens is, the bull goes on, stocks get cheaper.
Since ’90, we’ve had some tremendous, whether you look at price to trailing earnings or price to forward estimates, price-earning multiples coming down. This is exactly what happened here. We started this thing with, like, 30, sometimes, trailing earnings. We’re now down to 26 times trailing earnings, but I think we’re going to be close to 20 times trailing earnings going into next year.
Twenty sounds extraordinarily high, for you and me, or anyone that’s been in the business for a while, because that was kind of the top end of the range prior to 1990. But 20, in the last 30 years, are average. It’s the average price to trailing earnings multiple. And I think we got a shot at going into next year at an average PE of around 20 times, net trailing earnings. Now, I didn’t even talk about how low rates are, but I think this market is far better valued than what people think, and maybe you’re going to see some stories, as we enter into next year, that suddenly it’s looking more reasonable, if you will.
That’s one thing I’d throw out. The other thing I’d throw out is on corrections. We could certainly get a correction any time. I think they’re really difficult to call. And the problem with corrections is, you think one’s coming, and then the market goes up another 5% before it starts, and then you have a 15% correction, and then when it’s bottoming out, you’re not sure it’s bottomed out, so it has to come up 5% before you’re convinced. And by the time you get through that, I don’t know if it pays to really put a lot of effort into it. I would be more inclined if two things existed. One is, if I thought the bull market was more at a risk of ending soon, or the economy was at risk of rolling over, which I think there’s always a risk, but I don’t think that’s very high.
And secondly, I just don’t see the normal forces. Normally, bond yields have been going up, not down. Normally, inflation fears are strengthening, not kind of weakening off or moderating. Normally, the Fed’s been tightening for a while, and fiscal policy’s been tightening for a while. Normally, we hadn’t had a bunch of rolling corrections, where everything’s been corrected on some kind of relative basis, including technology, over the last year. I would be more inclined to expect one after bond yields go back up, after inflation fears reignite, once the Fed’s kind of into official tapering overall. We’ll see about it, I guess.
Meb: All right, so, we’re going to slide down with a couple more questions before we let you go. You’re an economist, we put you on a desert island, or in an ice fishing shack on the lakes in Minnesota, and I say you can only have a couple charts or indicators, Jim. Like, any that are particular favorites when you’re kind of scanning through? I’ve seen you talk about hundreds, if not thousands, over the years, but are there any that hold a particularly near and dear to your heart, either that are unknown, or ones that are well-known, you just happen to think have a lot of weight?
Jim: What I try to do, over the years, is not get wedded necessarily to any one thing. Because what I’ve found out is, I find things all the time that work fabulously, and then they blow up. And that’s just what happens to them. I can tell you relationships that have been that way, that you could trade big money and make big money, and then suddenly, one day, that just didn’t work. And that happens over and over again.
I think the markets remake themselves frequently, and it’s very difficult. I think that’s why hedge funds blow up. I think that’s why those things happen. But here’s what I do. I am constantly looking at new things, as well as old relationships. And what I do is go with the weight of that evidence where it takes me. If I’ve got a number of things telling me one thing, I’ll be more inclined to do that. So, that’s kind of how I go about doing things.
And a lot of those are new things. You know, when you read my things, you’re going to see new indicators that, by gosh, I just found, too, quite frankly. But, more important to your point, if there’s one thing you say to me that’s the most important, I think it’s always trying to figure out where is the consensus? What is their mindset? And where could they be wrong?
Because if you can tell me, whatever the consensus is, is why prices on everything are where they’re at the moment. Whether it’s dollar, or stocks, or bonds, doesn’t matter. That reflects the cumulative buy and sell decisions of a consensus of individuals. So, what you got to figure out at all times is, of the consensus beliefs that are driving prices, what among those are the most vulnerable to shift away from what people think?
And if they do, what will that do to different prices that you could exploit? And there’s really a host of things that go into that. There are all kinds of sentiment majors and things of that nature, or it might just be a focus variable, that the culture’s totally focused on. I mean, over my time, you know, in the ’80s, it was all about crude oil pricing for a while. It was all about the money supply, weekly money supply. It was all about unemployment claims. It just changes.
What is the focus variable at the moment? And how could that shift that would force a lot of players to change what they believe? That’s what I try to focus on the most. And again, it’s not any one thing, indicator, but that concept, I think, is more important than anything. More important than growth rates, or, is just how strongly-held beliefs that are embedded in prices can shift.
Meb: It’s always interesting when I have a belief or an idea, and find myself on the giant consensus. It makes you nervous. It doesn’t have to be wrong. Like, that’s…consensus seems to be right most of the time, but when it gets into extreme territory, it makes me definitely sit up and notice for a bit. And you look back on your career, what have been some of the most memorable, and you can pick one if you can think of one, but more, if not, moments in, like, as an economist, that you’ve… I mean, because you’ve been through ’87 crash, like, the, all sorts of ’90s emerging market, different, Mexico, and Asian flu, Y2K, on and on, COVID. Any in particular that standout as being particularly memorable for one reason or another?
Jim: Well, there are things you remember. You know, I certainly remember the ’87 crash probably better than anything, I think. Mainly, you know, I had this bright idea in the early ’80s about you needed four markets, stocks, bonds, currencies, and commodities, to fully appreciate and split the financial markets. So, started a fund where if you go long and short, I thought you should be able to do both, and I ran it into the … and I ran it on quantitative models back then, and I ran into ’87, and it just killed me. It just washed it out. I learned a ton from that, quite frankly.
So, the whole ’87 experience, to me, even though I saw market correction coming, I just didn’t expect it to be as extreme. That even told me something about leverage, and about… And what I remember the best is that I was doing so poorly in 1987 that during the day that it was collapsing, I finally decided to leave to get a breather. I just couldn’t take this anymore. Get away from the Quotron. And we needed a television, so I went to Best Buy to get a TV. And I walk in, and wall-to-wall was nothing but the stock market crash. And so, absolute wrong decision to do it. I think I’ve become more and more immune to weird happenings, just because I just feel like that’s kind of been, every year, every period’s been there.
Meb: I was joking with someone the other night. We were, speaking of time, completing the circle from the beginning of the podcast, was talking about Mexican food at the beginning of this, and was having a margarita, and let’s talk about markets in general, and say, you know, I don’t know what would surprise me at this point. You know, I mean, we’ve seen so much…if you studied history, you know that even crazier stuff has happened, but even then, weird stuff will always happen in the future. Like, the example I was giving, I said, we had the longest stretch of up months in the stock market in the U.S., and that was only a couple years ago, first calendar year where every month was up.
And then of course, last year, fastest ever all-time high bear market bounce, boom. We were joking, made the extension one step further. We were like, well, there’s a earthquake, while we were having dinner, here, which, it’s not a big one for LA, 4.7. And so, I was like, you know, if we found out that that was actually caused by aliens that live at the center of the earth, it was like, I don’t think my worldview would be that surprised. Be like, “Okay, that sounds crazy, but all right.” You know, like, that’s… So anyway, that’s my approach to markets, is to, like, have an appreciation for history, the full understanding that things could be different and weirder in the future. And maybe aliens, who knows?
Jim: I agree with you. I’d believe just about anything anymore.
Meb: Would alien discovery be bullish or bearish for stocks? That’s a good question. It opens up the total addressable market. All of a sudden, you have a potential for multi-planetary economic good, trade. It’s got to be bullish.
Jim: It’d sure increase world capital, I think, is what it would do.
Meb: Well, Jim, look, this has been fun. Where…can people, they want to track what you’re up to, your writings, your charts, your missives, where do they go? What’s the best places?
Jim: You just go to leutholdgroup.com, and you can look for the Paulsen Perspective. And I write, you know, generally a couple times a week. I mostly just write when I got something to write about.
Meb: I love your content. And, we’ll have to check in in the coming months to see what weirdness we’re experiencing in the world in 2022 and beyond. Jim, it’s been a blast. Thanks so much for joining us today.
Jim: Well, thanks, Meb, for having me. And thanks, everybody listening to me ramble on. I really appreciate it.
Meb: Podcast listeners, we’ll post show notes to today’s conversation at mebfaber.com/podcast. If you love the show, if you hate it, shoot us feedback at firstname.lastname@example.org. We love to read the reviews. Please review us on iTunes and subscribe to the show anywhere good podcasts are found. Thanks for listening, friends, and good investing.