March 2011

Economic and Market

2011-Issue 2

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: Stocks Still Offer Potential!?! Stay Overweighted Emerging, Smalls, And Cyclicals!!? Job Market Has JUMPED To Life! The Productivity Trade-Off?? Money Supply NOT Inflation-Scary??! Seven Percent Unemployment Key For Wages!!? Is E.M. Inflation Good For D.M.??? 10-Year Average VIX At Post-War High??? Trading Volumes Are Okay!!? Back To The Old Valuation Range!?!

The stock market recovery is two years old and has nearly doubled since March 2009. The low-risk, high-reward part of the investment cycle is probably over. A couple years ago, a consensus of investors had priced securities for the second coming of the Great Depression. When asset prices already reflect the worst possible nightmare, how could they go any lower? Indeed, when a recovery rather than a depression resulted, they could only surge higher. Perhaps the last couple years were the lowest investment risk years in the post-war era simply because most perceived they were the riskiest. The national mindset has turned somewhat more optimistic, the economic recovery finally appears sustainable, most risk asset prices are no longer being priced ridiculously cheap due to widespread panic, deflation risk has seemingly passed while inflationary concerns are slowly awakening, and economic officials are nearing a point of policy reversal. Against this rapidly changing landscape, questions are numerous and the decisions facing investors seem increasingly challenging. In the next year, what will be the economic backdrop driving the financial markets? After doubling in price, does the stock market still offer any upside? Will cyclicals, small caps, and emerging market stocks continue to lead the rally or is it time to lift exposures to defensive, large cap domestic stocks? How serious is the inflation threat? Will the Fed begin to tighten this year? Will bond vigilantes act even if the Fed remains reluctant? What will be the fate of the U.S. dollar?

Economic Backdrop?
Recently, the biggest event in the economy is a noticeable upswing in job creation brought about by the combination of a surprisingly strong ongoing profit recovery, a slowing in business productivity growth, and a rise in general confidence. In the last few months, several indicators suggest improved job momentum including: a drop below 400,000 in initial weekly unemployment claims, a decline in Challenger job cuts to levels not seen since 2000, a leap in both the ISM manufacturing and services sector employment survey components, an improvement in small business new hires survey, and finally recent improvements in the monthly job gains reported from the ADP, payroll, and household employment reports. Job gains appear likely to average about 225,000 per month this year compared to slightly less than 100,000 last year. This implies about 2 percent annual job growthenough to produce about 4 percent real GDP growth, lower the U.S. unemployment rate by about 1 percent a year, and make the economic recovery feel very normal as the year progresses. Undoubtedly, problems and worries remain including Middle East tensions, sovereign debt issues, municipal budgetary contractions, continued weak housing and commercial construction markets, and heightened concerns about inflation, bond yields, and potential Fed tightening. However, contributions to growth from business investment spending (driven by recessionary pent-up demands, a continued strong profit cycle, and by cash-rich balance sheets), renewed consumer spending (boosted by the return of jobs, rising confidence, and improved income growth), and additional gains in net exports particularly from emerging world economies (the U.S. dollar has declined by about 20 percent against emerging world currencies since 2009) should overwhelm any subtractions to real GDP growth forthcoming from weaker government spending or flattish construction trends. Inflation will likely rise this year and inflation fears will almost certainly worsen. However, U.S. inflation remains very low; so far, inflation pressures are confined solely to non-core prices, and excess capacity (both in the labor market and in factories) is pervasive with the economy exhibiting a near post-war record output gap. Therefore, while inflation may become more problematic in the future, during the coming year, core consumer price and wage inflation seem likely to rise only moderately.

Economic & Market Perspective

Interest rates should also rise only modestly this next year. We do expect the Fed to lift the funds rate to 50 basis points during the second half of the year. The rationale for a zero interest rate economy will likely dissipate. By this summer, the U.S. economic recovery will be two years old. If inflation indicators are rising while monthly job gains average over 200,000 in the next several months and real GDP growth accelerates to about 4 percent, what possible argument can the Fed offer to keep interest rates at zero? A minuscule rise in short-term interest rates to 0.5 percent is not likely to broadly or significantly hurt financial fortunes but would begin to improve the flow of investment income for savers. They wouldnt even have to admit they are tightening. They could simply suggest a hike is merely a move toward renormalization of the money market yield curve. If the Fed does begin to raise interest rates later this year, how will the financial markets respond? Will bond yields rise and stock prices decline, as investors interpret the Fed hike as the punch bowl finally being taken away? Or, will the stock market rally because of the first vote of confidence by the Fed in the sustainability of this economic recovery? Finally, long-term yields will also likely rise in the next year. Worsening inflation anxieties, a hike in short-term interest rates, rising confidence in a sustained economic recovery, and the end of QE2 (round two of quantitative easing by the Fed) should push the 10-year Treasury yield a bit higher this year. Currently, annual wage inflation is less than 2 percent and annual core consumer price inflation is 1 percent. Even if core consumer price inflation rises to 2 percent in the next year, the 10-year Treasury yield would be fairly priced at about 4 to 4.25 percent. Ultimately, long-term interest rate risk depends on inflation. However, for the coming year, we anticipate only a moderate rise in both.

reach a level between 1,400 and 1,450 sometime during the year and forecast it will at least reach its all-time high of 1565 before the economic recovery concludes. Beyond the next 12 to 24 months, the fate of the stock market depends on inflation. Inflation is clearly bottoming and if it eventually spirals out of control (e.g., annual core inflation rates rising to between 4 and 7 percent or above), the kneejerk reaction of both bond vigilantes and the Federal Reserve to arrest inflation will likely abort both the stock market rally and the economic recovery. Runaway inflation would likely cause the stock market to peak near its old record high and continue a trading range which has been in force since 2000. Although significant inflation would likely end the stock market rally, even under this scenario, stocks would not likely decline much below current levels. Why? Economic growth would probably have to strengthen considerably for inflation to become truly problematic. Stronger economic growth combined with greater corporate pricing flexibility would keep earnings rising strongly. Currently, the consensus earnings estimate for this year is about $96. Should economic growth and inflation accelerate aggressively during the next few years, peak recovery cycle earnings would likely rise to at least $120 to $130. Even if the price-earnings multiple collapsed to about 10 times earnings, due to rising inflation and higher interest rates, the expected downside risk for the S&P 500 would only be about 1,200 to 1,300, not much lower than today. Alternatively, if inflation remains moderate in this recovery, the stock market could embark on a new buy and hold era. If the annual rate of core consumer price inflation is contained below 3 to 3.5 percent, as it was in the last 20 years, the recovery peak in the 10-year Treasury bond yield would not likely be much higher than 5 to 5.5 percent. The Federal Reserve wouldnt be forced to aggressively renormalize the funds rate and instead could adopt a slow and steady policy progression back to a conventionally sloped yield curve where the funds rate peaks between 3 and 3.5 percent. A relatively moderate trajectory for inflation and interest rates would support an ongoing economic recovery, one which would slowly reabsorb the post-war high 7 percent output gap and 9 percent labor unemployment rate. A multi-year 3 to 4 percent real GDP growth recovery would calm fears of overheating, slowly revive crisis-shattered economic confidence and once again awaken the animal spirits imperative to a secular bull market. Not only could stock prices simply follow a steady earnings stream higher, but with moderate inflation and interest rates, its price-earnings multiple would eventually rise toward the upper-teens. Under such a scenario, another doubling in the stock market over several years cannot be ruled out. Even though prospective returns for stocks are not nearly as good as they were a couple years ago, when the S&P 500 bottomed at 676, its risk-reward character still remains favorable.

Stock Market ... Any Upside Left???

Even with heightened inflation concerns and a probable Fed tightening, in the coming year, the combination of solid real GDP growth and relatively modest inflation and interest rate pressures suggest a hospitable environment for stocks. However, since the stock market has recently doubled, is it already fully- or over-valued? The stock market has been primarily driven by a surprisingly solid earnings recovery and by the reversal of an investor panic. Consequently, despite its recent surge, valuations have not risen much. At its recession low in March 2009, the S&P 500 Index sold at about 13.5 times the one-year forward consensus earnings estimate. Today, this valuation metric is only about 13.7 times! With accelerating real GDP growth, persistently stunning earnings reports, a 1 percent annual rate of core consumer price inflation, wage inflation less than 2 percent, and a 10-year Treasury yield at only about 3.5 percent, a sub-14 times price-earnings multiple remains quite attractive. While a 5 to 10 percent correction at some point this year seems highly probable, its timing is very difficult to predict. Regardless of the specific path, we expect the S&P 500 to

Some Thoughts on Portfolio Composition?!?!

The investment climate remains complex. Interest rates are low, but risk asset prices have surged in the last couple years.

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March 2011

The economic cycle has become self-sustaining but the Federal Reserve will soon begin leaning against the economic recovery. Optimism has broadened in recent months even though most confidence measures remain severely depressed. The stock market continues in a broad trading range evident since 2000, but conditions may be forming for another prolonged buy and hold investment cycle. While struggling with these dichotomies, we offer a few thoughts on some of the major decisions facing every investorstocks or bonds, large or small cap stocks, cyclicals or defensives, and domestic or international exposures? Stocks vs. Bonds? Despite a doubling in the stock market during the last two years, portfolios should maintain maximal overweighted positions toward stocks relative to bonds. An eventual correction in the stock market is forthcoming but because its timing is extremely difficult to determine, most investors should stay focused on the long-run risk return profile. Much of the past couple years was less about stocks beating bonds, than it was about both markets renormalizing from what proved to be a ridiculously overstated depression-panic. This implies stocks are not nearly as stretched today relative to bonds as they normally would be after a doubling in price. Moreover, we could be in the early stages of another buy and hold era which certainly would favor staying significantly overweighted towards stocks. But even if inflation rages out of control during this recovery, the stock market will likely fare better than high quality bonds. Finally, confidence among businesses, consumers, and investors remain closer to recession lows than recovery highs, cash on the sidelines remains immense, stock mutual fund flows have just recently turned mildly positive, and the postGreat Crisis mindset has left most retail portfolios woefully under-allocated to the stock market. Large Cap or Small Cap Stocks? Since the crisis ended in 2009, most have recommended large cap stocks even though they have chronically underperformed. While conditions may change later this year, currently the environment continues to favor small caps. First, monetary conditions continue to expand and because small cap stocks tend to be less liquid, they do best when liquidity conditions are robust. Second, small cap stocks have mostly outperformed since emerging world economies have been leading the global cycle beginning in the early-2000s. Emerging economies are comprised by small companies involved in commodity and industrial pursuits and the character of this new world leader seems to be reflected by investment leadership among domestic small cap stocks. Third, small companies should benefit from a reversal in U.S. international trade flows. Most small companies face a marketplace which is primarily domestically domiciled. During the 1990s, a chronic worsening in U.S. trade acted to persistently shrink market share for many small companies. Recently, as the U.S. trade deficit improves, small domestic companies are enjoying an expanding marketplace. Fourth, real economic growth seems to be accelerating and typically small cap stocks do best until economic momentum slows. Finally, small company stocks have tended to outperform when inflation conditions worsen. For example, small caps solidly outpaced during the

high-inflation 1970s, did poorly during the 1980s and 1990s disinflation era, and have again done well since commodity prices have mostly surged since the early-2000s. Cyclical or Defensive Sectors? Similar to small cap stocks, economically sensitive stocks have outpaced since the recovery started, tend to lead while economic momentum accelerates, and typically do well until policy officials have been tightening for a period. Moreover, like stocks versus bonds, much of the outperformance of cyclicals in the last couple years is simply a reversal of the crisis panic which caused these stocks to suffer severe underperformance. Certainly cyclical stocks will experience periodic setbacks, but we believe investors should stay overweighted in most cyclical sectors. Technology stocks should benefit from massive excess cash reserves on business balance sheets, from pent-up demands for new-era spending built up not only during the last crisis but during much of the last decade, from a mini-innovation cycle emerging from the convergence of different technologies into a single device (e.g., iPad), from increasingly penetrating the new emerging world consumer marketplace, and from expanding government sales as they look for ways to increase efficiencies to help with budgetary woes. The manufacturing sector is leading the U.S. economic recovery for the first time in decades. The industrials, materials, and transport sectors are benefiting from extremely strong productivity growth, strong top-line industrial pricing flexibilities, healthy balance sheets, and improved international competitiveness owing to modest wage growth, strong labor productivity, and a weak U.S. dollar. Finally, consumer cyclical companies are enjoying the early stages of a recovery in the U.S. household sector. The household debt service burden has been reduced to below average, household liquidity holdings are extremely high, the savings rate is at a 20-year high, net worths are rising again, and job creation is just now notching higher. Domestic or International Stocks? We believe developed stock markets offer similar return profiles. Each of these economies are recovering from the last recession, are challenged by slow demographic growth, and by large private and public debt burdens. Their recovery growth rates will likely be similar, and since none can afford to lose precious growth to another country, via international trade, exchange rates among developed economies should stay within broad trading ranges. Emerging economy stock markets, however, should continue to outpace developed alternatives. Not only will economic growth rates likely remain far stronger in these regions, but we also anticipate a slow but steady devaluation of developed economy currencies against the emerging world. Consequently, by staying overweight emerging market stocks, U.S. investors should benefit from repatriation gains.

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

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Economic & Market Perspective

Job Market has Jumped a Notch!!!?

Several diverse indicators suggest the job market has jumped a notch in recent months. Initial weekly unemployment claims have recently declined below 400,000, Challenger U.S. layoff announcements have fallen to the lowest level since the top of the technology boom in 2000, the ADP employment report has surged to around 200,000 monthly gains in the last few reports, the NFIB small business survey New Hires Index has risen to a new level after being stalled near record lows since the recovery began, and finally both the ISM manufacturing and services sector Initial Weekly Unemployment Insurance Claims 4-Week Rolling Moving Average employment components have advanced solidly above the 50 percent level (signifying expanding payrolls). Probably, several months from now, payroll report revisions will show the economy began creating more than 200,000 jobs monthly late last year. While monthly payroll reports will remain volatile, we expect the average monthly gain to be about 225,000 this year up from slightly less than 100,000 during 2010. If this occurs, by year-end, the recovery should seem quite normal!??

Challenger U.S. Job Cut Announcements

ADP National Employment Report Monthly Change in Private Jobs

Thousands

NFIB Small Business Survey New Hires Survey Index

ISM Manufacturing Employment Survey Index

ISM Non-Manufacturing (Services Sector) Employment Survey Index

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March 2011

The Productivity Trade-Off??!?

For the third consecutive time, productivity surged early in this recovery allowing companies to match recovering demands without greatly expanding payrolls. However, as during both the early-1990s and early-2000s recoveries, productivity growth has recently slowed and boosted job creation. The economic trade-off of solid productivity growth is illustrated in this chart. The dotted line shows detrended productivity (when it rises, productivity is growing above its long-run average) and the solid line illustrates the real wage rate. Since the mid-1990s, even though productivity growth was mostly strong minimizing job creation, rising productivity also tended to increase the real wages of those who were working. Contrast this with the 1983 recovery. Productivity growth tended to be weak in the 1980s instantly producing solid job gains but also a chronic decline in real wages. Which is better? Stronger job creation even if real wages fall for every job holder or sluggish initial job creation but with solidly rising real purchasing power for those who are employed?

Real Wages vs. Business Productivity NonFarm Business Productivity Index Percent Above or Below its Long-run Trendline Average (Dotted) *Jobless Claims as a Ratio of U.S. Labor Force Inverted Scale (Dotted)

Consumer Confidence is ALL about Jobs?!??

Consumer confidence is all (or at least mostly) about job breaking to new highs as job layoffs decline to new lows. If creation. This chart overlays the Consumer Confidence job creation continues to improve this year, so will consumer Index (solid line) with the ratio of jobless claims divided confidence. Not only should the economy benefit from more by the U.S. labor force (dotted lineshown on an inverted people with jobs but also from those already employed feeling scale). Currently, it is no coincidence consumer confidence is more confident about spending. Consumer Confidence vs. Job Market* Conference Boards Consumer Confidence Index Natural Log Scale (Solid)

U.S. Inflation-Adjusted Wage Rate Natural Log Scale (Solid)

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Economic & Market Perspective

Money Supply is NOT Inflation-Scary??!

Despite unprecedented post-war monetary easing by the Federal Reserve, growth in the U.S. money supply remains moderate and, at least currently, is more suggestive of sustained economic growth than indicating either heightened inflationary or deflationary risks. The three-year annualized growth in the M2 money supply is around 6 percent, moderate by historic standards and in line with its growth rates during the last couple decades. The challenge facing the Fed of course is how fast they can drain excess liquidity as monetary velocity accelerates. However, as this chart illustrates, the relationship between money supply and economic growth is not currently signaling any major inflationary concerns?!??

*3-Year trailing annualized growth rates. GDP is GNP until 1946. Money Supply is M1 through 1958 and M2 thereafter.

Nominal GDP Growth vs. Money Supply Growth*

Commodity Prices No Longer a Good Developed World Inflation Signal!!?

Will surging commodity prices eventually cause a more broadly based U.S. inflationary problem? As this chart shows, at least until 2000, commodity price movements were closely associated with major changes in the annual core consumer price inflation rate. Since then, however, even though commodity prices have soared, the core consumer Core Consumer Price Inflation and Commodity Prices price inflation rate has trended lower. Does the break in this relationship have something to do with the new emerging economy leadership? This is the second global recovery led by emerging economies and for the second consecutive time, U.S. commodity price trends seemingly have little relationship to broader wage/consumer price trends!??

Annual Core Consumer Price Inflation Rate (Solid)

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S&P GSCI U.S. Commodity Price Index Natural Log Scale (Dotted)

March 2011

Seven Percent Rate Seems Significant for Wage Inflation?!?

Since 1970, a 7 percent labor unemployment rate has proved an inflection point for wage inflation. In the top chart, every move in the unemployment rate above or below 7 percent is circled and the corresponding period is labeled below on the wage inflation chart. Whenever the unemployment rate has risen above 7 percent (mid-1970s, early-1980s, early-1990s and in 2009), the annual rate of wage inflation was near a peak. Conversely, if the unemployment rate was above 7 percent during the recession, annual wage inflation did not typically accelerated until the unemployment rate again fell below 7 percent (e.g., 1977, 1987, and 1994). While the U.S. inflation cycle has bottomed (and already commodity prices have risen and core producer price inflation is accelerating), this chart suggests wage inflation will not likely experience any major acceleration until the unemployment rate again reaches 7 percent!?!

U.S. Labor Unemployment Rate

U.S. Annual Wage Inflation Rate

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Economic & Market Perspective

E.M. Inflation GOOD for D.M.???!

Could rising emerging world inflation be good for the U.S. economy? Yes! A positive trend in two major variables (exchange rates and relative inflation rates) would help turn international trade flows with emerging economies toward the U.S. Any combination of a weaker U.S. dollar exchange rate or a slower rate of wage and price inflation versus emerging economies (by making U.S. goods and services more attractive to both foreign and domestic buyers) would tend to improve the U.S. trade deficit and thereby add to overall real GDP growth. As these charts illustrate, the U.S. was making U.S. Dollar Emerging World Currency Index*
*Geometric-weighted currency index of the U.S. dollar against 11 leading Emerging Economy currencies. Number of foreign currency units per U.S. dollar.

progress on both fronts until the crisis erupted in 2008. Then, until about mid-2009, the U.S. lost competitive advantage to emerging economies. Fortunately, however, since mid-2009, the U.S. currency is again weakening against most emerging currencies, and the price of U.S. labor and goods have been rising more slowly than in the emerging world. Both trends suggest a healthy emerging world trade contribution to U.S. economic growth during the next couple years! Faster emerging world inflation may not be all bad?!?

Source: Economist Magazine

U.S. Economy Much More Dependent on Exports!!!?

This chart is a good reminder of just how fast and how dramatically the U.S. has been thrust into the global economy. Until 2000, real exports grew about in line with domestic real GDP growth. However, in the last five years, real exports have risen by almost 3 percent for every 1 percent gain in real GDP! U.S. Export Growth Relative to Overall GDP Growth**

**Rolling 20-quarter regression coefficient of the quarterly percent change in U.S. real exports to quarterly percent change in U.S. real GDP. Essentially, this coefficient shows the growth in real exports due to a 1 percent rise in real GDP.

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March 2011

Maybe Yields Dont Rise Much???!

This chart overlays the 10-year Treasury yield since the start of the recovery in June 2009 with the pattern of the 10-year Treasury yield during each of the last two economic recoveries. Many expect yields to eventually rise significantly during this recovery. During the last two recoveries, however, at no point during the entire economic recovery, did the 10year yield rise any higher than 50 basis points above where it started the recovery. When this recovery began in June 2009, the 10-year yield was at 3.5 percent. Is it possible the 10-year government bond yield will not rise much above 4 percent during this recovery? Probably not. However, the last two recoveries began with a much higher core consumer price inflation rate than in the contemporary recovery, possessed a much lower output gap, and suffered from a period of rising inflationary expectations. Bond yields are not likely to decline much from current levels, but unless inflation really gets out of control, perhaps ultimate peak cycle yield risk is not nearly as high as most perceive?!??

10-Year Treasury Bond YieldRecovery Cycles* 1991, 2001, and Current Economic Recoveries
*Percent yield change from the end of each recession (i.e., March 1991, November 2001, and June 2009)

Household Cash Hoards Still Excessive!!?!

This chart overlays U.S. household cash holdings as a Today, however, household liquidity balances remain percent of net worth with the level of short-term interest significantly elevated (probably because of lingering rates. Normally, the level of cash holdings is primarily financial fears) relative to interest rates. This chart suggests determined by the level of interest rates. Historically, when considerable risk asset buying power remains on the cash returns rise, household cash hoarding increases and sidelines and could yet prove a force pushing the stock when interest rates have been low so were cash holdings. market higher as confidence recovers??! U.S. Household Cash Holdings vs. Interest Rates U.S. Household Liquid Assets Holdings as a Percent of Household Net Worth (Solid)

Federal Funds Interest Rate (Dotted)

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Economic & Market Perspective

Second Coming of the Great Depression ... Way Overblown!!?!

Comparing the 2008 crisis to the Great Depression is common but probably a tortured analogy. This chart looks at the history of real GDP growth. Although during the 2008 crisis, annual real GDP growth did decline by more than in any recession in the post-war era, its decline wasnt even remotely close to the depressionary decline in 1933, the secondary recessionary decline in 1937, nor the post-WWII recession. At least four other recessions since 1950 suffered annual declines in real Annual Growth in U.S. Real GDP GDP which were very close to the decline suffered in 2009. The 2008 recession is more appropriately combined with the bad recessions of post-war history. To suggest it was anything like the Great Depression or even that the U.S. economy was close to such an event (even though it is still widely referred to as the worst recession since the Great Depression or as simply the Great Recession) seems greatly over-dramatized and wholly misleading?!!

10-Year VIX at Post-WWII High??!!

This chart examines the history of the stock market VIX Volatility Index. VIX is an implicit measure of option pricing volatility. Specifically, this chart shows the trailing 10-year rolling average VIX volatility level. In the last decade, the VIX Index is at its highest average since 1945! Not sure what this means. But do note, the best stock market returns have typically occurred when the average VIX was either trend less (e.g., 1920s or the 1980s and 1990s) or when U.S. Stock Market VIX Option Pricing Volatility Index* 10-Year Rolling Historic Average of Daily Values the average VIX was trending lower (e.g., 1945 through the 1960s). The worst stock markets have materialized when the average VIX trends higher (e.g., 1930s, 1970s and 2000s). Only during the 1930s was the 10-year average VIX Index higher than it is today. Consequently, unless a second depression is forthcoming, average VIX levels will likely either trend sideways or declinean event which has traditionally been good for stock investors?!?

*Daily VIX values were estimated from the daily changes in the natural log of daily closing prices from the U.S. Stock Market. Dow Jones Average used before 1928 and the S&P 500 Index used thereafter.

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March 2011

Financial Market Correlations Remain Very High?!!?

Correlations among the returns of major asset classes remain abnormally elevated. The trailing 6-month correlation of daily percent changes in the stock market and commodity markets is almost 0.7nearly twice as high as any time since at least 1970 when the U.S. dollar peg was suspended. Stock prices and Treasury bond yields have been oddly positively correlated since 2000 and even the relationship between Treasury yields and commodity prices has been irregularly correlated since the mortgage crisis began. The average cross correlation between all three of these major asset classes (shown in the top chart) has started to decline in recent months but still Average Financial Markets Correlation Coefficient* remains remarkably elevated. Until the dot-com boom, the average financial market correlation was negative most of the time. After surging into positive territory during the dot-com bust, this correlation did return to normal (i.e., a negative correlation) during the early-2000s economic recovery. In a similar fashion, we suspect the surge in average financial market correlations during the 2008 crisis may well return to normal again if the recovery persists and as confidence improves. If this does occur, asset class allocations should provide increasing diversification as the recovery matures??!

*Trailing 6-month average correlation between the stock, bond, and commodity markets. Average of three rolling 6-month correlations: 1. Daily percent changes in the S&P 500 vs. daily changes in the 10-year Treasury bond yield; 2. Daily percent changes in the S&P 500 index vs. SPGoldman commodity price index; 3. Daily changes in 10-year Treasury bond yield vs. daily percent changes in SPGoldman commodity price index.

**Rolling 6-month correlations between daily percent changes in SPGoldman commodity price index and daily percent changes in S&P 500 stock price index.

Commodity Prices vs. Stock Prices**

***Rolling 6-month correlations between daily changes in the 10-year Treasury bond yield and daily percent changes in S&P 500 stock price index.

Treasury Bond Yields vs. Stock Prices***

Treasury Bond Yields vs. Commodity Prices****

****Rolling 6-month correlations between daily percent changes in the 10-year Treasury bond yield and daily percent change in SPGoldman commodity price index.

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Economic & Market Perspective

Household Pent-Up Demands ... Good for Stock Market?!?

Periods where consumer pent-up demands rise (i.e., spending on big-ticket durable items is suspended for a period leading to increased pent-up demands) have typically been followed by a better stock market. The solid line in the top chart is the detrended level of the S&P 500 Stock Price Index. A rise (decline) in the solid line illustrates periods when the stock market is rising faster (slower) than average. The dotted line shows the level of real household spending on bigticket durable items (including durable goods and housing expenditures) as a percent of its trend line historic average level. The dotted line is shown on an inverted scale (i.e., a rise in the dotted line implies rising pent-up demands brought about Stock Market vs. Big Ticket Consumer Spending* because big-ticket spending has grown slower than average) and is pushed forward or leads the stock market by five years. The lower charts show both the stock market and real bigticket spending against their respective trend line averages. Currently, the level of real spending on big-ticket items is about 15 percent below its trend line average suggesting a considerable rise in household pent-up demands. While this relationship has certainly not been perfect, the likelihood of improved household big-ticket spending in the next several years (after several years of big-ticket liquidation) bodes well for stock investors?!?

*Big ticket consumer spending includes spending on housing and durable goods. Its percent from trendline average (dotted line) is pushed forward or is leading by 5 years or 20 quarters and is shown on an inverted scale.

S&P 500 Stock Price Index vs. Trendline Level

S&P 500 Stock Price Index (Solid) 60-Year Trendline Level of Stock Market (Dotted) Shown on a Natural Log Scale.

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Big Ticket Durable Consumer SpendingPercent Above/Below Trendline Average Inverse Scale (Dotted) Real Big Ticket Consumer Spending vs. Trendine Level
Real Consumer Spending on Durable Goods plus Real Residential Investment Spending (Solid) 60-Year Trendline Level of Big Ticket Consumer Spending (Dotted) Shown on a Natural Log Scale.

S&P 500 Index Percent Above/Below Trendline Average (Solid)

March 2011

Rising Commodity Prices GOOD for Small Cap Stocks!!?

The chart below overlays the relative stock price performance of small cap stocks (solid line) with non energy commodity prices relative to core consumer prices. When low-stage commodity prices outpace consumer prices, small company stocks tend to outpace large company stocks. For the last couple years, most have expected large cap stocks to dominate leadership in the stock market. However, unless commodity prices suffer a prolonged decline or begin to rise more slowly than consumer prices, small cap stocks will likely continue surprising most and again outpace large cap stocks!!?

Small Cap Stocks vs. Non-Energy Commodity Prices

Russell 2000 stock price index divided by S&P 500 stock price index (Solid, Left Scale) S&P GSCI Non-Energy commodity price index divided by core consumer price index (Dotted, Right Scale) Both scales are shown as a natural log.

A New Secular Cyclical Stock Led Era??!!

This is the second global economic recovery led by the emerging world. This could be good news for economically sensitive or cyclical stocks. From 1980 to 2000, the global economy was led by developed countries which were mainly comprised by relatively economically stable consumer unit growth or service franchise companies. During these two decades, leadership in the stock market was usually dominated by stable stocks while most often cyclical stocks underperformed. However, since the emerging world began leading the economic cycle in 2000, cyclical stocks have typically dominated outside of recessions. Investors may want to consider staying with larger portfolio exposures to those sectors which better reflect the character of emerging economies (e.g., industrials, materials, and transports)??!

*Relative Stock Price Performance. Morgan Stanley Cyclical Stock Price Index divided by Morgan Stanley Consumer Stock Price Index Natural Log Sale.

Cyclical vs. Stable Stocks*

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Economic & Market Perspective

Good Time to Buy Emerging Market Stocks!!??

Emerging market stocks have only matched the returns from the S&P 500 Index in the last year and have only been market performers for more than three years. Moreover, since November, emerging stocks have significantly underperformed. We still like the emerging economy leadership story and believe emerging stocks will continue to outperform in the years ahead. This period of consolidation is likely an opportunity for investors to increase exposure. As this chart illustrates, the relative price of emerging stocks reacted similarly at the start of the last economic recovery. After an initial surge of outperformance from the recession lows beginning in late2001 and continuing into early-2002, emerging stocks were only market performers during the next year or so before again reestablishing market leadership in 2004.

Emerging Market Stocks vs. U.S. S&P 500 Index Relative Total Return Performance Natural Log Scale.

Stock Market Trading Volumes Better Than Perceived!??

New York Stock Exchange trading volumes have trended lower since the crisis began in late-2007. This has created the widely accepted impression that investors left the stock market during the crisis and have never returned. However, examination of a total measure of stock market trading volume, which combines trading done on multiple exchanges, Total NYSE Volume* Trailing 60-Trading Days Average Volume
*In millions of shares traded only on the New York Stock Exchange Source: Bloomberg

tells a different story. Although trading volumes did decline during the 2008 crisis, they subsequently recovered and remain at healthy levels. Based on total trading volumes, the crisis did not cause investors to permanently leave the stock market??! Total U.S. Trading Volume* Trailing 60-Trading Days Average Volume
*In millions of shares traded on every U.S. exchange including NASD, OTC, and OTCBB Source: Bloomberg

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March 2011

Still Upside Potential for the Stock Market!!?

In the 75 years leading up to WWII, the price of the U.S. stock market rose at about 1.8 percent per annum. Since 1945, however, it has appreciated at about 7.3 percent annually. The top chart overlays the U.S. stock market with its two distinct trend lines and the lower chart records the percent by which the stock market resides above or below its trend line level. At the low in March 2009, the stock market was about 60 percent below trend line. Currently, despite almost a doubling of the stock market, it still remains about 20 percent below trend. Before this recovery cycle has ended, the stock market will likely rise above its trend line average suggesting stocks still offer investors attractive return potential!?! The bottom chart illustrates the price-earnings multiple history of the stock market since 1870. Until 1990, the stock market valuation was U.S. Stock Market1870 to 2010* Actual Level vs. Trendline Level mostly range-bound between about 7 and 21 times earnings. By 1990, this valuation range had mostly contained stock market history for about 120 years and caused many investors to be strongly value-focused. However, for most of the next 18 years (until the 2008 stock market collapse), stocks traded almost perpetually above the upper historic band of the old valuation range. This abnormally long period when valuations seemingly did not matter produced an investment culture much less focused on value. Since the crisis, however, stock price-earnings multiples once again have traded within the old valuation range. If this persists, will a renewed valuefocused investment culture emerge and strengthen during the next several years??!

*Source: Cowles Commission and Standard & Poors. Log Scale.

**Source: Cowles Commission and Standard & Poors. Until 1945, used Trendline Level between 1870 and 1945. Thereafter, used Trendline Level between 1946 and 2010. Log Scale.

U.S. Stock Market1870 to 2010** Percent Above/Below its Trendline Level

Back to the Old Valuation Range? U.S. Stock Market Price-Earnings Multiple History***
***Price to trailing average 3-year annualized earnings per share. Sources: Cowles Commission and Bloomberg.

| 15 |

Economic & Market Perspective

Back to the Future Relative Stock Market Valuations???!

The valuation relationship between the stock and bond markets has returned to what existed between 1870 and the 1960s. Historically, earnings yields were always at a premium to bond yields. In an unprecedented fashion, during the 1970s, the earnings yield lost its traditional premium to bond yields. It traded nearly on par with bond yields during the 1970s; and between 1980 and 2000, bond yields chronically traded at a premium to stock yields. Since the dot-com collapse, the relationship between stock and bond yields began to return to old form, and in the 2008 crisis stock yields have fully regained their premium normal status relative to bond yields. What are the implications of this radical shift? Does this mean stocks are now finally cheap relative to bonds for the first time since the 1960s? Is this proof investors have indeed experienced a watershed decline in risk tolerances during the last decade? Or, did this relationship change for a few decades simply because the U.S. experienced an unprecedented surge in long-term yields which have now returned to normal historic levels? Not sure of the importance of this shift, but investors should be aware the stock-bond relationship has gone back to the future, and, at a minimum, is no longer similar to what has been in place for the last three to four decades. One final observation, between 1970 and 2000, stock and bond yields were highly positively correlated as illustrated in this chart. Indeed, a positive correlation between stock and bond yields has been typical throughout U.S. history. For example, from 1870 to 1900, both bond and stock yields mostly declined. Then, between 1900 and 1920, they rose in tandem. Similarly, between 1920 and 1945, they mostly declined again. Two periods stand out as different. First, the contemporary period, when since 2000, stock yields have risen while bond yields have declined, and second, the period between 1950 to the late-1960s when stock yields declined while bond yields were either flat or rose. Could this happen again? Given how low bond yields are today, it seems a good bet either they stay low or rise in the next several years. Could the era ahead resemble the 1950 to 1960s period? Since earnings yields are currently again so much higher than bond yields, could earnings yields decline (stock prices rise) even in the face of rising yields???!

U.S. Stock Market Earnings Yield vs. Long-Term Bond Yields Source: Shiller data until 1953 and Bloomberg thereafter. Earnings yield based on trailing 5-year average annual share earnings.
Stock Market Earnings Yield (Solid) Bond Yield (Dotted)

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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