The possibility of the U.S. going into another recession has gone from a theory reserved for perma-bears to the dominant conversation on the Street. After scoffing at recession talk all through the Spring, "the smart money" in the bond market and high-end punditry are putting the odds of a second dip at 50/50 or worse. Keep in mind, recession is typically defined as negative economic growth (or GDP) for two consecutive quarters. Lost in the conversation is this: With stocks more than 10% off their highs, economic expectations near rock bottom, and no optimism to be found, would the U.S. officially slipping into a recession actually matter in a meaningful way?
"If we don't have a recession, we're going to be close to $100 of S&P500 earnings by the end of this year," says Jim Paulsen, chief investment strategist at Wells Capital Management. So yes, according to Paulsen, staying out of a recession does matter and not just for national self esteem. He says a dip into the darkness could take $25 to $30 off that bottom line. At 1,200 or so on the S&P500 that means stocks are trading at either 12x 2011 earnings or 16 to 17x. Historically speaking, 12x earnings is relatively cheap and a multiple of 17 would be pricey even in a rosy growth environment.
In my view, a drop from sub-1% growth into something barely under zero in terms of GDP doesn't add up to anywhere near $25 of earnings. Paulsen says I'm starting my math from the wrong spot. The "GDP number is kind of woefully understated," he says, placing the actual growth somewhere above 2% for the first 6 months of 2011 and 2.5% for the third quarter just ended. Citing the admittedly meager job growth numbers, Paulsen adds that going from "creating 150,000 jobs a month to losing 150,000 jobs a month...that's a big deal."
Understated or not, GDP figures are notoriously flawed, as are the jobs data and just about any other figure coming out of Washinton, D.C. Political bias, incompetence, and the impossibility of measuring the largest economy in the world all play a hand in making one-off data points neither accurate nor useful. But Paulsen has a few other measures coming in better than expectations, including net exports, factory orders, personal consumption expenditures, durable goods orders and everything but the Vikings covering the spread last weekend.
What's more, the amiable Paulsen says the drop in commodity prices that killed Alcoa's (AA) 3rd quarter results will be a boon for retailers and consumers. Global growth may be slowing but local demand may balance it out in terms of earnings, or at least come close enough to an offset to allow for earnings growth to come in fairly well.
Paulsen mentions two chief reasons the economy simply avoiding a recession makes for a compelling trading thesis into at least the end of the year:
1. We're in the "most crisis-phobic investment culture we've had in the entire post-war era," he says. I'll concede this point, but suggest that economic catastrophes seem to happen every 2 to 5 years and make a little phobia seem rational. Still, investors have been kicked in the face so many times over the last few years simply avoiding a worst-case-scenario could unleash some animal spirits and cause what Paulsen calls a return to greed.
2. Finally, Paulsen points to the resistance from 1,220 to 1,250 on the S&P500. Seemingly everyone is watching this level as their key to the next big move. If and when stocks can somehow get a toe-hold beyond the former support at 1,250 there's going to be a whole lot of fund managers who feel way too light on stocks in their portfolios. And those who are under-invested are the lucky ones; the shorts will start getting taken out in a box.
So yes, whether or not we go into a recession does matter to your portfolio but not in the way you may think. As Paulsen sees it, a tip into recessionary territory would likely keep markets grinding lower, given the number of people already expecting the worse. Avoiding a dip into negative growth on the other hand, is going to catch enough traders off-sides to catalyze an impressive, perhaps even stunning, rally into year-end.
Jim Paulsen is not married to the number but he's leaving his year-end forecast for the S&P500 at around 1,350. Let us know if you think that makes him crazy like a fox or just nuts.
- Jim Paulsen