'UNACCEPTABLE': Former investment strategist warns of 'red flag' in economy

Key Concepts:

• Red Flag Economy
• Equity Metrics as Economic Indicators
• Walmart vs. Luxury Retailers (Inverse Relationship with Real GDP Growth)
• Bloomberg U.S. Inflation Sensitive Equities Relative Total Return Index
• Cyclical Sectors (S&P 500)
• Employment Services Stocks
• Real GDP Growth
• Unemployment Rate
• Job Creation
• ADP Numbers
• Inflation Expectations
• Bond Market Break-Even Rates
• Accommodative Economic Policies
• New Era Segments (Tech Stocks)
• Small Caps
• Equal-Weighted S&P
• Value Stocks
• Deep Cyclical Sectors
• International Stocks
• Money Supply
• Yield Curve
• De Facto Safe Haven

Introduction: Contrasting Economic Views The discussion begins with Charles noting Dollar General's exceptional performance, ranking as the "number two gainer in the entire S&P for the past month." However, guest Jim Paulsen presents a counter-argument, labeling this strength as a "red flag" for the broader economy. He describes the economy as "pretty punk," despite the Atlanta Fed's more optimistic assessment.

Jim Paulsen's "Red Flag" Economic Assessment

Data Void and Reliance on Equity Metrics: Paulsen attributes his divergent view to a "void in the data" stemming from the government shutdown, which has rendered much official economic data "out of date." To gain a more current perspective, he relies on "equity metrics," which are "daily priced" and provide timely "warning signs."

Specific Equity-Based Warning Signs: Paulsen identifies several equity-based indicators signaling economic weakness:

• Consumer Spending Shift: He observes "Walmart significantly outperform[ing] luxury retailers." This trend has historically demonstrated a "good inverse relationship with real GDP growth" and is currently "pointing straight south."
• Inflationary Pressure Indicators: The "Bloomberg U.S. Inflation Sensitive Equities Relative Total Return Index" has been "collapsing here in the second half of this year." This index maintains a "really close relationship with commodity prices" and suggests "downward pressure" on inflation.
• Industrial Production Proxy: The "relative performance of the cyclical sectors of the S&P 500" has "come down a lot" since the government shutdown, a trend closely related to "industrial production."
• Job Market Health Indicator: The "relative performance of employment services stocks" has "really gone south," indicating a weakening in "the job markets."

Specific Economic Data Points: In addition to equity metrics, Paulsen highlights concerning traditional economic data:

• Real GDP Growth: He estimates it's "stuck around 2%," which he considers "almost at unacceptable levels."
• Unemployment Rate: The unemployment rate has "risen a full percentage point in absolute historical, unique fashion in this recovery to 4.4%."
• Job Creation: Year-to-date job creation is growing at a sluggish "about one half of 1%," with recent "ADP numbers" suggesting a further deterioration. Paulsen concludes that the economy is "weaker, and we're going to get more policy support as a result."

Implications for Monetary Policy and Inflation

Declining Inflation Expectations: Charles notes a trend of "inflation expectations starting to come down," citing the "Michigan Sentiment number" and data from the "New York Fed." Paulsen further supports this by mentioning that "break-even rates in the bond market," specifically the 1-year rate, have remained "flat around 2.6% now for the last couple years," reflecting embedded inflation expectations.

Fed's Room for Accommodation: Paulsen believes these declining inflation expectations provide the Federal Reserve "a lot of room" to adopt "more accommodative" policies in the coming year. He argues that if the choice is between addressing "runaway inflation or a really weak jobs market," the "job market that wins" in terms of policy priority.

Investment Opportunities: Shifting Leadership from "New Era" to Broader Market

The Invariance of Tech/New Era Stocks: Paulsen posits that "tech and new era stocks" have become "invariant to normal cyclical forces and economic policies." He attributes this to their substantial size and growth driven by their "own innovative cycles."

The Need for Policy Support in Older Economy Sectors: Conversely, the "older parts of the economy very much need policy support." Paulsen contends that the current bull market has been the "least policy-supported bull market we've ever had," resulting in its "narrow" nature, heavily concentrated in a few large tech companies.

Potential Beneficiaries of Accommodative Policies: Should the economy receive "more support, better, more aggressive accommodative economic policies," Paulsen anticipates a significant shift in market leadership. He expects "broader areas" to begin "beating the new era sectors." These include:

• Small caps
• Equal-weighted S&P
• Value stocks
• Deep cyclical sectors
• International stocks (a trend "already happening" with a weaker dollar) He explains that improving the "money supply" and "steepen[ing] the yield curve" would particularly benefit "cyclical stocks and value stocks."

Reasons for Tech's Past Dominance and Potential Shift: Paulsen acknowledges that tech stocks' popularity stems not only from their "fantastic" fundamental performances but also from their resilience "when everything else has been horrific." They effectively became the "de facto safe haven" for investors. However, he predicts that if "the rest just starts doing better," it will "detract some of the popular" appeal from tech, potentially signaling a rotation in market dynamics.

Synthesis and Conclusion Jim Paulsen offers a detailed counter-narrative to prevailing economic optimism, leveraging real-time equity metrics to expose underlying weaknesses across consumer spending, inflation, industrial production, and the job market. He asserts that the economy is "pretty punk," characterized by rising unemployment (4.4%) and stagnant GDP growth (around 2%), necessitating "more policy support." This environment, combined with declining inflation expectations, provides the Federal Reserve significant latitude for "more accommodative" policies. Paulsen argues that such a policy shift would likely broaden market leadership beyond the dominant "new era" tech stocks, benefiting "older parts of the economy" and sectors like small caps, value stocks, and international equities, which have been underserved in the current narrow bull market. This suggests a potential rotation in investment opportunities as the broader market responds to increased policy support.