October 2011

Economic and Market

2011-Issue 3

Bringing you national and globalglobal economic trends for than 25 years Bringing you national and economic trends for more over 25 years

In This Issue: No U.S. Recession!?! Economy Is SelfMedicating!!? Bad Market Signals?!? Good Market Signals?!? 2012The Gear Year??! Four Fed-Based Policies!!? Stock Market To Follow Main Street!!?

Since its collapse in early August, the stock market has experienced extreme daily price volatility oscillating within a broad range. These emotional daily price swings reflect a skittish investor struggling with a dichotomy between extremely attractive relative stock market valuations and an array of escalating fears. Investor worries include a widening contagion from the European sovereign debt crisis, the potential for a hard landing among emerging world economies, uncertainty introduced by uncommon and confusing Federal Reserve policy actions, and the likelihood of yet another debt ceiling debate looming on the horizon. While these concerns should keep daily price volatility elevated, how the stock market ultimately breaks from its recent trading range will probably be determined by whether the U.S. economy avoids recession. In the next several weeks, economic reports will either galvanize recession expectations or consensus fears will once again calm, embracing the likelyhood that the U.S. economic recovery will persevere. Should a recession become obvious, the stock market would likely suffer a further significant decline. Alternatively, investor greed may dominate the rest of this year should recession fears fade as investors act to take advantage of a valuation metric (about 11 times earnings with a sub-2 percent 10-year Treasury) which, without a recession, represents a fire sale!

A U.S. Recession?
An imminent U.S. recession is unlikely. First, the traditional economic policies which precede a recession are not evident. The U.S. does not possess an inverted yield curve, has not been subjected to significant short-term nor long-term interest rate hikes, and is not suffering from restrictive liquidity conditions or tight fiscal policies. Second, can the U.S. suffer a recession when there is nothing to recess? Recessions often result from excesses in need of a correction. Since the last recession ended only two years ago and since it was so extreme, private sector players have thus far been well-behaved in the contemporary recovery. Are individuals paying up too much for houses today? Have consumers extinguished pent-up demands for durable goods? Is the savings rate too low (the savings rate has been hovering about a 20-year high since the recovery began)? Are household debt burdens oppressive (the household debt service burden is in its lowest quartile since 1980 and no higher today than it was in 1985)? Have banks been aggressively overextending loans? Has anyone been borrowing too much lately? Are companies overstaffed? Overinventoried? Have businesses over invested in the last couple years? Has the Fed tightened too aggressively? Have bond vigilantes raised bond yields too much? Too much fiscal tightening lately? Is anyone lacking for liquidity? Are households overexposed to the stock market today? Is optimism over the top? It is hard to see why the U.S. would experience a recession when almost nothing requires a correction. Indeed, before the next U.S. recession, the answer to at least some of these questions will likely be yes! Third, despite a significant economic slowdown since early this year (annualized real GDP growth rose only 0.7 percent in the first half and real GDI growth rose by only 2 percent), the economy is already showing some signs of bouncing. After flattening earlier this year, real personal consumption is on pace to rise more than 1.5 percent in the third quarter, weekly retail chain store sales have remained relatively robust, and the annualized U.S. auto sales rate has risen by more than 14 percent since June to 13.1 million, helped by Japan bouncing back from its tsunami. Weekly unemployment insurance claims remain in the low 400,000 range, reported private sector ADP employment gains have averaged 100,000 in the last two months and layoff announcements as recorded by the Challenger Job Cuts Index have remained subdued.

Economic & Market Perspective

Corporate profits are still robust, industrial production posted back-to-back gains in July and August, and recent reports for factory orders and durable goods shipments suggest business spending may have accelerated. The ISM manufacturing survey surprisingly increased in September to 51.6 and the ISM services survey is at a solid 53.3. Finally, U.S. net exports improved significantly in July suggesting international trade will add to third quarter growth. Overall, we expect real GDP growth to be between 2 to 2.5 percent in the third quarter hardly a recessionary reading. Fourth, new policy stimulus added in recent months should soon improve the pace of economic growth. Many worry the Fed is out of bullets and fear fiscal authorities have been neutralized by gridlock leaving the economic recovery without policy assistance. Although the abilities of policy officials may be limited, the economy has turned to self-medication. The national average 30-year mortgage rate has fallen from 5.2 percent in February to only about 4 percent today! Similar yield declines since the spring have been recorded by investment grade corporate bonds and by municipal securities. This large decline in long-term credit costs should help boost economic performance in the next several months. Both consumers and businesses should also get a boost from lower energy cost. Crude oil and gasoline prices have declined by more than 20 percent from peak levels earlier this year. Furthermore, even though the U.S. dollar has recently risen, the real broad U.S. Dollar Index is still about 10 percent lower today than it was in 2010 suggesting additional improvement is forthcoming in U.S. trade flows. The U.S. M2 money supply has exploded since June growing at an annualized pace of about 25 percent! Finally, as Japan bounces back from its economic collapse after the early-year earthquake, U.S. manufacturing supply chain problems should alleviate further in the next several months. Indeed, U.S. auto sales have already strengthened significantly in recent months as the Japanese impact diminishes.

(i.e., those that actually expand the central banks balance sheet and thus represent a true easing of monetary conditions), and even entertain a European-style TARP program similar to the U.S. approach used in 2008 to backstop ailing banks. After almost two years of smoldering into a major economic threat, there is understandably great concern the crisis cannot be controlled nor extinguished. However, the lack of success to date is primarily because so little has been done to address the crisis. This is beginning to change and will likely lead to much better results in the coming year. The most serious threat for the U.S. economy is not a period of sluggish or nonexistent Euro region growth but rather a full-blown global financial contagion. Although possible, this seems highly unlikely in our view. First, the problems are well-known and have been for some time. A more serious financial contagion could hardly be a surprise which is often the most difficult aspect of crises. Second, most U.S. financial institutions do not hold large amounts of troubled sovereign securities. Third, even if a financial contagion were to infiltrate the U.S. financial system, because of responses to the 2008 U.S. crisis, the U.S. system is now very well capitalized, it has already experienced a major write down of bad debts, and is more highly liquid than in decades. Perhaps this is why for the first time, European and U.S. 10-year government swap spreads have significantly delinked. Euro swap spreads have exploded to 2008 wides while U.S. spreads remain near their lowest levels of the last decade. The more likely U.S. fallout from the Euro crisis is a sluggish Euro region economic performance which would reduce U.S. export markets. While this is very likely, it may have much smaller impact then most fear. Outside of the Euro region, economic growth is likely to be maintained including Japan, Canada, Australia, the emerging world economies, and in the U.S. It is worth remembering that in 1990 the worlds largest economy at the time, Japan, fell into a depression from which it would not return. Nonetheless, the rest of the world including the U.S. proceeded to enjoy an economic boom during the balance of the 1990s! Today, the world economy is comprised by a new economic force (emerging world economies), which did not exist in any meaningful fashion in 1990, which should help diminish the impact of a smaller growth contribution from Europe.

What About Europe?

Unlike the U.S., the Euro region has been subjected to significant monetary and fiscal tightening in the last year and does exhibit characteristics of a pre-recessionary economy. However, how serious is the risk of either a recessionary or sluggishly growing Euro region for investors? The best news surrounding the Euro crisis is it has finally gotten so bad! When the Euro sovereign debt crisis first broke in January 2010, the major players (EMU policy officials, Germany and France) perceived the problem as a political issue. Consequently, the crisis has not received any substantial assistance aimed at ending the economic and financial contagion. Only recently have the major powers in the region decided it is an economic threat and have begun to treat it more appropriately. Since officials have done so little yet to arrest the crisis, many weapons are still left in the tool box. Only recently, EMU officials finally suggested they will stop raising interest rates. Soon they will begin to lower interest rates, perhaps pursue some non-sterilized bond purchases

How About China and the Emerging World?

A much more serious blow to the global economic recovery would be a recession in the emerging world. Despite widespread fears of such an event, we think a soft landing is a better description of what is happening among emerging world economies. During much of 2010, investors worried about China and other emerging economies overheating and collapsing. As a result, most emerging economy policy officials have been tightening conditions in the last year leading to a noticeably slower growing emerging world. However, now policy officials in this region are beginning to turn back toward easing policies after most economies have slowed. For example, Chinese real GDP growth has slowed

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to a still very robust 9 percent rate from about 12 percent last year. This is probably a healthy development and makes it more likely the global economic recovery will prove longer-lasting. Recently, China reported the second consecutive monthly rise in its manufacturing ISM survey to 51.2 in September! The easing policies now being increasingly employed throughout the emerging world suggests a quicker economic growth from this part of the globe in the coming year.

recession valuation given a sub-2 percent 10-year Treasury bond yield. Moreover, we believe if a recession does actually occur, panic will likely cause a much deeper decline in earnings producing further downside risk in the stock market. Fortunately, we believe the chance of a U.S. recession remains quite low. If, during the next few weeks, the upcoming jobs report shows positive gains (even if sluggish) and if unemployment claims, retails chain store sales, and other timely economic data do not fall off a cliff suggestive of a recession, investor greed will likely return and begin to dominate the financial markets. If a consensus comes to believe a U.S. recession is off the table, the current valuation metric of less than 11 times year-end earnings while the 10-year Treasury yield is at a record low will become far too enticing. We think a consensus which agreed the economic recovery will persist would result in a stock market willing to pay perhaps around 14 times for 2012 earnings of between $105 and $110 or a target price of about 1500! This is not necessarily our forecast for next year, but rather an illustration of the investment potential which exists should consensus recession fears fade. The incredible daily volatility exhibited by stock prices during the last two months is frightening and tiring. It seemingly makes no sense when valuations can change so radically, so quickly, with little or no new fundamental information. However, the character of these types of markets, these periodic gut checks, may be what is in store for investors during this highly crisisphobic period in financial history. Our best guess is investors should try to stay focused on fundamentals and not on the markets daily assessment of its worst crisis fears. Ultimately, we believe the U.S. and global economy is in a recoverya recovery which will prove bumpy but will also likely prove persistent. And, if it does, those investors which approach this decline in the stock market as an opportunity to raise exposure to cyclical sectors will likely fare best in the coming years.

Market Signals are Flashing Caution???

U.S. recession expectations have risen primarily because several financial market indicators are providing signals which often precede a recession. That is, recession fears are due less to worsening economic fundamentals than they are being driven by worsening financial market signals. The good news is the old adage which goes something like the stock market has predicted 12 of the last five recessions. While financial markets always worsen prior to recessions, poor financial market action also frequently precedes temporary economic slowdowns or panics. Consequently, it is hard to interpret the message of the markets. However, given the extraordinarily fearful, crisis-phobic culture which has dominated since 2008, a good deal of caution should be employed when relying on survey reports and market signals (markets which have been amazingly emotional driven) to access where the economy is headed. We are certainly in the middle of an intense panic. A panic which may last longer and take financial markets even lower before it is extinguished. However, fundamentally the U.S. economy remains sound, has some momentum, and because of self-applied stimulus since spring, is likely to improve in the months ahead. Moreover, Euroland problems finally seem to be receiving the economic/ policy attention it deserved a lot sooner. Finally, the rest of the global economy, like the U.S., is still growing (more likely in a temporary slowdown) or even growing quite rapidly (e.g., emerging world). Contemporary financial market signals, owing to the current remarkably emotionally-volatile period, may be exaggerating upcoming economic problems and underestimating the potential for an economic reacceleration.

Outlook for the Stock Market?!?

The fate of the U.S. stock market during the balance of this year will not likely be determined by Euro crisis fears, by Fed actions, by a jobs bill, or by debt ceiling debates. Rather, the stock market is likely to be driven by whether or not the U.S. avoids a recession. That is, the stock market will ultimately rally or fail based on economic data flow coming from Main Street USA. Should the data convincingly portray a U.S. recession, the stock market will likely decline significantly further from current levels. With the S&P 500 Index currently slightly below 1100, the stock market already seems to be discounting a recessionary decline in earnings to about $70 (from the current likely yearend level without a recession of about $100). That is, based on this recessionary earnings expectation, the stock market currently sells at about 15 to 16 times which is a reasonable

James W. Paulsen, Ph.D. Chief Investment Strategist, Wells Capital Management

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Economic & Market Perspective

No U.S. Recession!??!
It is two months after the stock market collapsed during the first week of August and most economic indicators, while portraying a soft economy, do not (yet) suggest a recession. As it did before the 2010 economic slowdown ended, the economic surprise index has been rising quickly toward zero in the last month. At 53, the economy-weighted ISM manufacturing and services survey composite index remains far above recession territory. Despite weaker business confidence readings, weekly unemployment insurance claims have not spiked and remain in the same range they Citigroup U.S. Economic Surprise Index have trended in since the year began. Likewise, weekly retail chain store sales continue to grow at a pace near the fastest of this recovery. Finally, although both business and consumer confidence has been noticeably impacted in the last couple months by the collapse in the financial markets, both confidence measures have fallen to levels no worse than they did during last years economic soft patch! It is encouraging most timely economic data continues to suggest a recession will be avoided. Economy-Weighted U.S. Manufacturing & Service Sectors ISM Survey Composite Index

Initial Weekly Unemployment Insurance Claims 4-week Moving Average

Johnson Redbook Same Store Retail Sales Index Year over Year Growth Rate of Weekly Sales

U.S. CEO Economic Confidence Index Source: Chief Executive Magazine

Conference Board Consumer Confidence Index

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Believe it or Not...
Most believe this recovery simply isnt working, is growing more slowly than any other post-war recovery, and has worsened considerably this year. Believe it or not the annualized growth of real Gross Domestic Product (GDP) and real Gross Domestic Income (GDI) during the first two years of the contemporary recovery is very similar to the performance of the last two recoveries in 1991 and in 2001. While the growth in real GDP during the first eight quarters is slightly less than the last two recoveries, the pace of real GDI growth has been slightly stronger. Overall, U.S. economic growth has been slower since 1985. So while there is a new-normal, this new-normal is already 25 years old! The current recovery may be sluggish and disappointing Real GDP During First 8 Quarters of Recoveries 1991, 2001, and Current Economic Recoveries
*Real GDP measures economy from the spending side. Ratio of Real GDP to Level at End of Recession Ratio of Real GDI to Level at End of Recession

compared to recoveries in earlier post-war times, but its character and speed are remarkably similar to U.S. economic recoveries during the last 25 years. For this reason, we remain confident the current recovery is not broken, and like the last two recoveries, will likely prove successful. Moreover, despite the slowdown this year, believe it or not, a couple major aspects of the recovery have improved this year. For the first time credit creation among both households and businesses is growing again, and so far in 2011, average monthly private job creation has risen almost twice as fast as last year (i.e., 145,000 monthly private job gains this year vs. only 98,000 last year)! Real GDI During First 8 Quarters of Recoveries 1991, 2001, and Current Economic Recoveries *Real GDI measures economy from the income side.

Number of Quarters Since End of Recession

Number of Quarters Since End of Recession

U.S. Business Borrowing U.S. Bank Loans plus Nonfinancial Commercial Paper

Total U.S. Consumer Credit Outstanding

Average Monthly Private Job Gains In Thousands

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Economic & Market Perspective

Economy is Self-Medicating!!?
Many worry U.S. policy officials are out of bullets. The Fed has already provided massive liquidity and lowered interest rates to zero and fiscal authorities look hopelessly gridlocked until after next years election. For this reason, most do not anticipate any improvement in economic growth since policy officials seemingly can no longer add meaningful juice to the recovery. We disagree! The economy doesnt need further assistance from policy officials since it is selfmedicating! Mortgage, corporate, and municipal bond yields have collapsed from earlier year highs. Gasoline prices are 30-Year National Average Mortgage Rates off by about 20 percent since May. The real U.S. Dollar Index is about 10 percent below its high in 2010 which should help improve U.S. international trade in the coming year. The M2 money supply has been surging at about a 25 percent annualized rate since June and since the Japanese economy has bounced from its tsunami earlier this year, U.S. auto sales (and other manufacturing supply chains) have shown significant signs of healing. We expect better economic growth due to the lagged impact of the self imposed policy stimulus the economy has been enjoying!

M2 Money Supply Annualized 13-Week Growth Rate

National Average Unleaded Regular Gasoline Price

U.S. Trade-Weighted REAL Broad Index

Total U.S. Auto Sales

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Bad Market Signals??!

The collapse of the financial markets during the last couple months have produced some scary signals about economic growth. So far, however, most of these bad market signals are not flashing recession. The 10-year Treasury bond yield has declined to an all-time record low below 2 percent. Normally, this would suggest the economy was headed for recession. However, this market has been greatly distorted by highly irregular Federal Reserve quantitative easing policies (i.e., massive buying of Treasury securities) and by a recent pledge by the Fed suggesting interest rates would remain low until at least mid-2013. If not for these extraordinary actions, the 10-year bond yield may not of declined any further than it did during the 2010 economic soft patch. Although stock market action in the last couple months has been shockingly volatile and even though the selloffs have been emotionally violent, so far, the S&P 500 Index is down by about 20 percent from its recovery cycle high. This is slightly more than the 16 percent decline S&P 500 Composite Stock Price Index Shown on a natural log scale. U.S. Annual Wage Inflation Rate experienced last year during the 2010 economic soft patch. Junk bond yields and their spread in yield relative to Treasury bonds have also spiked higher in the last couple months. So far though, their rise is little different than what occurred during last years temporary economic slowdown. Likewise, although many commodity prices have declined significantly in recent weeks, the declines so far are very similar in duration and magnitude to what happened last year. In contrast, emerging market bond yield spreads have widened much more than they did during 2010. However, this is probably appropriate since last year the emerging world economies did not suffer the pause in growth most developed economies did whereas this year all economies have simultaneously slowed. Overall, these market signals are worth monitoring and will become more concerning should they continue to worsen. For now, however, they mostly seem to reflect an economic slowdown rather than signal an imminent recession. 10-Year U.S. Treasury Bond Yield

JPMorgan U.S. High Yield Bond Index: Yield Spreads to U.S. 10-Year Treasury Bond (Solid) JPMorgan U.S. High Yield Bond Index: Yield to Worst (Dotted)

U.S. Junk Bond Yields and Yield Spreads

Emerging Market Bond Yields and Yield Spreads

JPMorgan Emerging Market Bond Index: Yield Spreads to U.S. 10-Year Treasury Bond (Solid) JPMorgan Emerging Market Bond Index: Yield to Worst (Dotted)

Spot Price of High Grade Copper Shown on a natural log scale.

U.S. 3-Month LIBOR Spread* *Difference in yield between the 3-month LIBOR rate and the 3-month U.S. T-bill rate.

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Economic & Market Perspective

Good Market Signals!!?

Among all the gloomy financial market signals, there are at least two which are positive or at least curious. The S&P 500 Consumer Discretionary Stock Price Index just rose to an all-time high relative to the overall stock market and the S&P 500 Information Technology Stock Price Index just reached S&P 500 Consumer Discretionary Stock Price Index RELATIVE Stock Price Performance its highest relative standing since the recovery began! If the economy is on the precipice of a recession, why are two of the most economically-sensitive stock market sectors leading the overall market? Is the consumer in much better health than most believe? S&P 500 Information Technology Stock Price Index RELATIVE Stock Price Performance

Emerging Markets and U.S. Manufacturing are Joined???

This chart overlays the relative total return performance of emerging market stocks with U.S. industrial commodity prices. It suggests the fortunes of emerging economies and domestic industrial/manufacturing companies are closely joined. So, if you are a fan of the future leadership of emerging market economies, perhaps you should also consider some investment exposure in domestic manufacturing companies?

Relative Total Return Performance of Emerging Market Stocks* (Solid)

Emerging Markets and U.S. Industrial Activity *Morgan Stanleys Emerging Market Stocks Total Return Index Relative to S&P 500 Total Return Index. Shown on a natural log scale. **CRB Raw Industrial Commodity Price Index. Shown on a natural log scale.

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CRB Raw Industrial Commodity Price Index** (Dotted)

October 2011

Risk #1Europe???
A collapsing Eurozone is of course an economic risk for all economies. Our view is the biggest risk for the U.S. economy is if a financial contagion in the region embroils the U.S. financial infrastructure. We think this is unlikely. First, as illustrated in the accompanying chart, we are encouraged the correlation between U.S. and Euro swap spread movements seems to have delinked this year. Although Euro swap spreads suggest financial stress, U.S. swap spreads do not suggest alarm. Second, if the U.S. does face some form of an imminent financial crisis, it could not come at a better time. The aftermath of the Great 2008 U.S. Crisis has produced a U.S. financial sector which is probably better capitalized and more liquid than it has been in decades. Moreover, direct holdings of troubled Euro sovereign debt by U.S. banks is not large. Euro problems will likely last for several years but there is reason to be optimistic. When this crisis first broke in January 2010, the major players (EMU officials, Germany, and France) perceived it was mainly a political problem and not an economic issue. Now, they finally recognize it as an economic crisis and are finally beginning to address it appropriately. Consequently, they have many weapons which could still be employed they could stop raising interest rates, they could slow fiscal austerity measures and focus more on growth, they could lower policy interest rates, they could undertake nonsterilized bond purchases, and they could adopt a Euro-style TARP program to backstop troubled banks. With so little yet done and with so much yet to bring to the problem, the outcome could prove far less damaging then most currently fear. Finally, what if the Euro region economy does enter recession or simply grows very sluggishly for the next several years? Would this be a death blow for the U.S. and other global economies? Perhaps, but remember that in 1990 the worlds largest economy, Japan, fell into a depression from which it would not return and yet the U.S. and other economies proceeded to enjoy an economic boom! 10-Year Government Swap Spreads Euro vs. U.S.
Euro Swap Spread (Solid) U.S. Swap Spread (Dotted)

Risk #2Emerging World???

From our perspective, a recession among emerging world economies would represent a much more impactual risk for the U.S. economy than does the Euro sovereign debt crisis. A loss of the emerging world economic leadership would make the likelihood of a continued global expansion remote. A year ago, many worried China was going to overheat and collapse. Now, most worry China will underheat and collapse. The pace of economic growth in the emerging world has indeed slowed. For the last year, most emerging world policy officials have been tightening in order to moderate their respective recoveries and orchestrate a soft landing. Currently, a moderated but continuing economic recovery appears most likely in the emerging world. For example, the China PMI Index was 51.2 in Septembera level reflecting a slowdown but not a recessionary level. Moreover, the China PMI Index seems to be bottoming. We expect the emerging world economic recovery to accelerate some next year since most emerging world policy officials have begun to adopt easing policies. Indeed, if emerging economies have achieved a soft landing, rather than representing a risk of an abrupt global cycle ending, it may imply an elongated global economic recovery. China PMI Manufacturing Survey Index

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Economic & Market Perspective

Why Wont Biz Spend Their Cash???

The enviable, powerful financial position of corporate America is widely recognized. Corporate balance sheets have not been this strong in decades. They are overflowing with about $2 trillion cash and they are enjoying one of the best profit recovery cycles in post-war history. The top chart shows the level of cash flow to capital spending is at its highest level in at least 50 years! The question many have is why, when corporate America is so financial healthy, they simply arent spending or hiring? The answer is actually they are! As illustrated by the lower left chart, private job creation has risen almost by as much in this recovery as it did at this point in the early-1990s recovery and by far more than it did during the early-2000s recovery. Moreover, as shown by the lower right chart, real business spending so far in this recovery has been far stronger compared to either of the last two recoveries. Corporate America is indeed buying and hiring! However, they could still do so much more! In the next few years as corporate confidence improves and the ratio in the top chart declines from 120 percent to its average of about 80 percent, it will leave a mark on Main Street USAin a good way! In the meantime, we will just have to settle for the second best private job creation of the last three recoveries and the strongest real business spending cycle in 25 years.

U.S. Corporate Net Cash Flow to Capital Spending Ratio

Percent Change Since End of Recession in NonFarm Private Payrolls

NonFarm Private Payroll Employment Percent Change During First 26 Months of Economic Recoveries Percent Change Since End of Recession in Real NonResidential Business Investment Spending

Real U.S. Business Spending Percent Change During First 8 Quarters of Economic Recoveries

Number of Months Since End of Recession

Number of Quarters Since End of Recession

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2012... The Gear Year??!

Although the contemporary recovery has been sluggish, both its character and speed are very reminiscent of the last two recoveries since the mid-1980s. The current recovery is slightly past the two year mark and consumer confidence remains depressed. However, as illustrated by the top chart, confidence was also lethargic two years into both the 1991 and 2001 economic recoveries. Moreover, even though it sometimes feels like the Federal Reserve will leave interest rates at zero forever, current Fed interest rate policy is also not that dissimilar compared to the last two recoveries. In March 1991, when an economic recovery began, the Fed would not raise rates again until three years later in February 1994. Similarly, the 2001 recovery began in November 2001, and the Fed did not raise the Funds rate again until July 2004! Essentially, the pace of economic growth remained so disappointing during the first three years of both the last two recoveries that the Fed did not raise rates until the fourth year of the early 1990s recovery and not until late in the third year of the early 2000s recovery. In similar fashion, as the current recovery enters its third year, there is no sign the Fed is close to raising interest rates. In fact, if the current recovery continues to follow the pattern of the last two recoveries, the Fed may not begin to raise interest rates until next summer! In the early 1990s, it took three years of economic recovery before the economy finally geared in 1994. When economic growth did finally accelerate in 1994, the long-term Treasury bond yield rose from 6 percent to 8.5 percent in nine months which resulted in the Orange County crisis. Similarly, the early 2000s recovery began in late 2001 but did not gear until 2004 when accelerating economic growth forced the Fed to aggressively raise the Fed Funds rate which led to an economic slowdown again by 2005. The fact the current recovery remains disappointingly sluggish at the two year mark is completely compatible with how recoveries have unfolded in the last 25 years. Moreover, if the trajectory of the contemporary recovery continues to closely track the pattern of the last two recoveries, investors may want to consider whether the economy finally gears during the last half of next year. That is, like 1994 and 2004, will late-2012 prove to be another gear year?

Consumer Confidence Index* and Recoveries *Conference Boards Consumer Confidence Index. Shown on a natural log scale. Shaded areas represent recessions.

Federal Reserve Policy ResponseFed Funds Rate 1991 Recovery

Federal Reserve Policy ResponseFed Funds Rate 2001 Recovery

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Economic & Market Perspective

Fear-Based Policy #1: QE2!!?

Fear has proven to be a significant problem in this recovery. On this page, and on the next three pages, we highlight four economic policies employed during this recovery (two monetary and two fiscal policies) which may have helped the recovery but which also had the unintended consequence of destroying confidence and raising fear. On this page we examine the Federal Reserves QE2 policy (i.e., the second round of quantitative easing) employed during the 2010 economic soft patch. Most seem to believe it was the implementation of QE2 in late 2010 which ended the economic soft patch. This has caused many to believe the economic recovery is not self-sustaining but rather is being kept alive only by policy official life-support systems. This belief has made the 2011 soft patch even more frightening since most believe the Fed is now running out of bullets and can no longer Stock Market vs. Federal Reserve Balance Sheet keep the recovery alive. We disagree. The top chart overlays the S&P 500 Stock Price Index with the Feds balance sheet. As illustrated, the stock market and indeed economic growth began improving in the summer of 2010 long before the Fed even began implementing QE2. We think what revived the economy in 2010 was not QE2 but rather was recovery stimulus provided by the economic slowdown itself. That is, like today, the economy self-medicated. As shown by the lower four charts, the M2 money supply began to accelerate in March 2010, the U.S. dollar started to weaken in June, and both mortgage rates and gasoline pump prices began significant declines in May. The combo self-employed policy package of faster money growth, a weaker dollar and much lower interest rates, and gas prices started to improve the economic recovery long before the Fed even implemented the QE2 program. We believe in 2010 the economy probably recovered from its soft patch on its own without any need of assistance from policy officials. If this view were more widely accepted, confidence in the sustainability of this recovery would already be much stronger. However, since the Fed acted with QE2 late in 2010 convincing most this policy action was necessary, it has created a predominant impression the economic recovery is broken and only being kept alive by Fed action.

Annualized 13-Week M2 Money Supply Growth Rate

Total Federal Reserve Assets (log scale) (Dotted)

S&P 500 Stock Price Index (log scale) (Solid)

Trade-Weighted U.S. Dollar Index

National Average 30-Year Mortgage Rate

National Average Regular Unleaded Gasoline Price

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Fear-Based Policy #2: Housing Tax Credits!!?

Fiscal actions have also elevated economic fears. Twice during this expansion, fiscal authorities introduced tax credits for first-time homebuyers which temporarily boosted housing activity only to produce a slump once the programs expired. Since after the first expiration, the tax credit was again extended, this pattern of a bounce followed by a slump was repeated two times. The charts below illustrate that the housing market (based either on a sales basis or a home price basis), seems to have clearly bottomed at least two years ago right at the start of this economic recovery. However, because the tax credit program expired twiceduring both 2009 and again in 2010it produced an impression and widespread fear the housing industry twice was headed for another doubledip collapse. While the introduction of this tax credit may have cleared some housing inventory, it also significantly raised and elongated fears of the potential for an extended and secondary collapse in the housing industry. We will never know, but if this tax policy hadnt been enacted, would most have agreed that the housing industry had reached a bottom by late-2009 or early-2010? And wouldnt this impression have led to a significant boost in confidence which may have already improved the pace of economic growth?

U.S. Existing Home Sales

Millions of Units

S&P/Case Shiller Composite-20 U.S. Home Price Index

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Economic & Market Perspective

Fear-Based Policy #3: Zero Interest Rates!!?

Like all recessions, the 2008 collapse required a much lower interest rate structure to help private sector economic players heal. However, did policy officials do more harm (to confidence) than good (by helping to improve fundamental balance sheet burdens) by keeping both short-term and longterm interest rates too low for too long? The Fed Funds interest rate has effectively been kept at zero since late 2008. The fundamental difference between a zero interest rate and a rate of 50 basis points is probably meaningless. Keeping the funds rate at 50 basis points rather than zero would not likely have much negative fundamental impact on most balance sheets nor credit creation. However, emotionally, the difference between a 50 basis point interest rate and a zero interest rate is dramatic. A 50 basis point Fed Funds suggest a very low interest rate. A zero Fed Funds connotes Fed panic, going the way of Japan, at the precipice of a depression, and being out of bullets! Similarly, by pledging yields would remain low until at least mid-2013 and by adopting operation twist the Fed probably pushed the 10-year Treasury yield to record lows below 2 percent. At sub-2 percent, the 10-year yield probably provides little additional fundamental balance sheet assistance but it certainly contributes to heightened recessionary/depressionary fears. Without question, the economic recovery since 2009 has occurred in part because the Fed decided to lower interest rates and thereby fundamentally improved the financial fortunes of many private players. However, the Feds decision to maintain the short-term interest rate at zero (and to push long-term yields to record lows) has probably also fueled chronic economic fears and contributed to keeping economic confidence low.

Effective Federal Funds Interest Rate

10-Year Treasury Bond Yield

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October 2011

Fear-Based Policy #4: 26 to 99 Weeks!!?

The persistently high unemployment rate has certainly been a confidence destroyer in this recovery. Despite a recovery which is entering its third year, the unemployment rate remains above 9 percent and it appears to be coming down much more slowly than during past recoveries. Why? Certainly, the primary reason the unemployment rate remains high is because the economic recovery has not grown fast enough. That is, job creation has simply been insufficient to significantly lower the unemployment rate. However, the lower two charts suggest another culprit might be responsible for at least some of the disappointment surrounding persistent joblessness in this recovery. While jobs are scarce today, the jobs hard to get survey suggests they are no harder to find then they were in most past recessions since 1970. However, if this is the case, why is the average duration of unemployment at record highs today? If jobs are no harder to come by today than they were in 1975, 1983, or 1992, why isnt the average duration of unemployment 15 to 20 weeks as it use to be rather than the 40+ weeks it is today? Could it be because the unemployed simply dont have the skills required by employers? If so, why wouldnt this show up in a much higher jobs are hard to get number? Alternatively, could these two charts be explained by a government policy which has dramatically extended unemployment benefits from its historical 26 weeks to 99 weeks? If individuals are paid longer to stay unemployed, wouldnt longer unemployment (at least at the margin) be the expected result? We are not suggesting the unemployed are taking advantage of the system. Clearly this is not the casejobs are hard to get today and most unemployed simply cant find work. However, could the expansion of unemployment benefits by almost four times the historic norm keep the unemployment rate (and particularly the long-term average unemployment rate) at least marginally elevated from where it probably would be today had the unemployment Average Duration of U.S. Unemployment In Weeks insurance program not changed? Would the unemployment rate perhaps be as much as 1 percent lower today had the unemployment insurance program not changed? At about 8 percent, the unemployment rate would have improved by about 2 percent since the recovery began and would be in line with the improvement which took place in the unemployment rate during the 1980s recovery. The unemployment rate would still be very high, but confidence the job market was slowly improving would also be much higher than it is today. Certainly, the extension of unemployment benefits has helped many worthy job seekers in the last couple years, but it has also probably kept fears much more elevated throughout the country that the economic recovery is simply not working.

U.S. Unemployment Rate

Conference Boards Jobs Hard to Get Survey

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Economic & Market Perspective

Stock Market to Follow Main Street!?!

S&P 500 Composite Stock Price Index (Log Scale) (Solid) The S&P 500 Stock Price Index has been stuck in a broad trading range since the early August. News flow from Europe, Fed comments, Presidential politics, and debt ceiling debates may continue to keep volatility in the stock market high. However, we think it will be economic data from Main Street which will ultimately determine the fate of the stock market during the rest of this year. This chart shows stock prices and unemployment claims remain highly correlated. If the U.S. economy is indeed headed for an imminent recession, unemployment claims should soon spike and the stock market will likely collapse even further. Alternatively, if the economy avoids recession, unemployment claims will likely begin declining again and the stock market should break out to the upside. Our best guess is a recession will likely be avoided, unemployment claims and other economic reports will prove better than feared and the reemergence of investor greed will likely produce a solid stock market rally before the year is over. Stock Market vs. Unemployment Claims 4-Week Moving Average of Initial Unemployment Insurance Claims (Log Scale) (Dotted)

Tough Decision...?!?... 50x... Or 11x... Earnings???

Until the 2007-08 crisis, the price-earnings multiples (PE) on both stocks and bonds were highly positively correlated. As shown however, the PE on the bond market has soared to about 50x recently while the PE on the stock market has declined to about 11x. What a dramatic valuation differential! This reflects just how much fear is dominating the investment landscape. The valuation divergence between risk (stock) and risk-free (T-bonds) assets has seldom been more pronounced. This chart also highlights substantial upside potential for stock prices (and equally impressive downside risk for Treasury bonds) should economic fears ever subside. Patient investors who stay with risk assets should eventually reap the gift which lessening fears and slowly rising confidence should provide in the next several years.

Price-Earnings Ratios U.S. Stock Market vs. U.S. Bond Market S&P 500 Price to Mean Estimated 1-Year Forward Earnings Estimate (Solid) 100 divided by U.S. 10-Year Treasury Bond Yield (Dotted) Shown on a natural log scale.

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Written by James W. Paulsen, Ph.D. 612.667.5489 | For distribution changes call 415.222.1706 | www.wellscap.com | 2011 Wells Capital Management