Jim Paulsen on Growth, the Fed and the Case for a Broadening Rally

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[00:00:24] If you look at real GDP growth through the first half of this year now, it's grown at just 1% annualized. I don't think it's any kind of number that anybody in the country, including policy officials, would be happy with. It's not the type of thing you want to hang around because it's so close to recession.

[00:00:42] The CPI inflation rate is 2.7%. That is unchanged from where it was in January of 2020 before the pandemic. It resided at that range almost all the time between 2017 to 2019. No one was worried about runaway inflation. We seem to be today.

[00:01:03] This S&P 500 is sitting at about 50% above trendline right now, which is the only time it's really been worse than that in any big way was the dot-com top. If I dig down a little deeper to the broader marketplace, what I find is while the S&P is really extended, if you will, relative to the trendline, much of the rest of the stock market is not. It's almost in the opposite position.

[00:01:30] Jim, thanks so much for jumping on with us again this month. You bet. It's always a pleasure. It is late August, and there's a lot of cross-currents and things going on in the markets and on investors' minds.

[00:01:42] The goals of these discussions is to get your view on the markets and the economy and look at, I think, what is some interesting data points and charts that you're putting out there to try to understand maybe what's important, what investors should be thinking about, the risks and opportunities on the horizons. And the things that, you know, sort of what we talk about on a daily basis and that you're thinking deeply about in your research.

[00:02:10] And just for anyone that is new to this and hearing this for the first time, or if you haven't checked it out, all of the material that is sourced from here is coming from Jim Substack. And you can learn more about that and register for free to his newsletter at paulsonperspectives.substack.com. So, thanks, Jim. And let's get right into it.

[00:02:34] And the first couple, I guess, discussion items here are not going to be chart-based, but we're interested to hear your thoughts anyways. You know, how are you thinking? What's your overall view of the economy right now? Yeah, well, a lot has changed even since we talked last month, Justin. And I think the biggest thing is just that, which is well-known, is the data kind of went south.

[00:02:59] And if you look at real GDP growth, we'll come to this a little bit later, you know, it's through the first half of this year now, it's grown at just 1% annualized. I think employment growth is down to about 2% annualized. And those are extraordinarily, you know, weak numbers overall.

[00:03:23] I don't think it's any kind of number that anybody in the country, including policy officials, would be happy with is 1% real GDP growth. It's not the type of thing you want to hang around because it's so close to recession. And so, you know, that's why the narrative has changed a little bit here, I think, more than anything. The jobs report being weak is what sent it off.

[00:03:44] But that's why it's really changed from just about inflation, what the Fed's going to do about that, and tariffs, to all of a sudden, oh, my gosh, you know, does the Fed have to do something more here for growth? I think that real economic growth is weak. I think it's still unlikely to recess. And I'll maybe throw a few things on why. But I think it's weak primarily because policy has been contractual and not really even just the Fed, but just in general. Fiscal policy is very strong.

[00:04:13] It's running about 6.25% of nominal GDP deficit spending, which is one of the greatest fiscal deficits in peacetime post-World War II history. So that's been off the chart on the strong side. But the even fiscal policy has been at about the same level now for more than two years, two to three years. It really has been flat. So there hasn't been additional fiscal juice.

[00:04:35] And if you factor in the tariffs on that, that makes fiscal policy even less expansive because tariffs, of course, are a tax and a negative. And if I go to the dollar, the dollar has come off now about 7% in real terms here from the start of the year, which is wonderful news. That's finally getting a stimulus involved. But the dollar is still within 10% of its all-time record high right now.

[00:05:02] After falling 7%, it's still 10% close to its all-time record high in March of 1985. It's been an extraordinarily contractionary dollar policy that's really, in the last 15 years, you could argue this is the most contractionary dollar, U.S. dollar policies we've ever employed since it was first floated in the early 1970s. The dollar is still up 33% in the last decade after falling by 7% from its highs.

[00:05:30] The dollar is an immense contractionary force. First, if you just think about operating in a global economy when the dollar goes up 33% over the last decade, you've got to try to get your costs down that amount. Your productivity up. It's an immense negative force. And that's still pretty tight in my view. And then you've got monetary policy, which by any standard, real money growth is at 1.8% right now. That's lower than 64% of the time since 1960.

[00:05:58] The yield curve is currently still inverted from the 10-year yield to funds rate, still inverted after we just had those job numbers at five basis points, which is lower than almost 80% of the time since 1970. The 10-year yield at 4.25% or 4.28% is at the same level today that it was when inflation was 9.1%.

[00:06:24] So inflation's gone from 9.1% to 2.7% and the 10-year yield hasn't moved at all. The mortgage rate is still at the same level today as it was when inflation was 9.1%. Despite a dramatic improvement in inflation, we've not changed the long-term rate structure and we've kept the yield curve inverted and we've kept money growth extraordinarily low. I think that's really a tight policy overall.

[00:06:50] M2 growth is 4.5% nominal terms year on year, which is identical to the rate of nominal GDP growth. Historically, when money growth is less than nominal GDP growth, real growth slows over the coming year. We are just finally back to even with that. It's nice. We're maybe going to finally get a hint, which would be a positive for real growth, but it's been a negative for so long.

[00:07:16] We had 16 months of negative year-on-year real GDP or real money growth in this country in the last couple of years after never being negative ever once since it first came out in 1960 on a year-on-year basis. It's been extraordinarily tight. The policy uncertainties out there are still pretty high. I mean, we've got trade uncertainties, we've got monetary policy uncertainties, we've got Trumpetility, which is a constant uncertainty.

[00:07:46] Who knows what he's going to come up with next? And I think it's really hard for companies to plan in that environment, and a lot of them just sort of sit back and wait and hoard cash. And, you know, who wants to hire or build with such volatility, which is still there overall. So I really think the economy still needs policy help, but I don't think we'll have recession.

[00:08:10] One more point that I might come back to a little bit later, corporate profits accurately are going to be reported this Thursday on August 28th. And they have been below their post-World War II trend line now for a decade, the longest period of time in post-war history where they've been below trend line. What is interesting is that S&P profits are 27% above their trend line, S&P 500 profit.

[00:08:37] But total U.S. profits are still 10% below trend line rate. And that's not happened. I think Justin got a chart a little later when you show where the divergence there has never been this big between what these large cap S&P companies are doing and what the rest of the universe is doing. And we'll come back to that. But I don't think you think about it. If we had a decade of below average profitability, do you think policy officials would be okay with that? I really don't.

[00:09:04] But because these large companies have done a fine, it feels like we're doing great. I think there's a lot of companies hurting overall and that need additional oil. The reason I don't think we're going to have recession, and we could certainly have a recession. I mean, it has a way of creeping up on you when you just don't know it. But my guess is no. And the reason I say that more than anything, I just wrote a piece this week that I looked at.

[00:09:30] There's so many characteristics today that are evident that you normally, you have never see them when you're heading into recession. And yet we have a large number of them. And that's just, I think it's going to be hard to recess when we have so many things that normally say no recession. I just real quick go through this.

[00:09:52] We've never had a recession in this country since World War II, at least, when fiscal deficit spending to GDP was as great or as expansory as it is right now. Never. We have, we've never had a recession in this country when confidence was this low as it is today. But pessimism is this high, if you will.

[00:10:17] Real GDP correlations, if I correlate the individual components of real GDP, 22 separate components making up real GDP. If I take their average correlation to overall GDP right now, it's almost at a post-war low. There's only been a couple of instances where it's been this low. That says there's the greatest diversity inside the economy going on. Some parts are doing well. Some parts are doing horrible. But there's not a consistency. Why is that important?

[00:10:45] Because when you look back historically, we have recessions that begin when there's high correlation among its components. Why? Because everything starts moving together and there's a boom. And then we bring the hammer down and shut it down. We don't have that. We got rolling recessions. Some things that never got out of recession while other things are doing okay. And that's not the type of environment that begets a recession. Never has, at least, in post-war history.

[00:11:13] We've also never dealt with the extent where debt or balance sheets have been improving for at least a decade to 15 years. Consistently improving in the corporate sector and household sector. That is, the profit or excuse me, the corporate debt to profit ratio and household debt to income ratios have been falling consistently for 10 to 15 years. After really rising all the time in most of the rest of the post-war history.

[00:11:39] I think there's a reason why, if you exclude the pandemic recession of 2020, which was only occurred for an exogenous reason. Not because the internals of the economy was bad. It was because we had this health, this weird virus that escaped China. It shut us all down. If you exclude that, we have not had a recession in this country since 2009. That's the longest period of time ever we've gone. Guess what?

[00:12:08] That dovetails almost identically with the time when balance sheets have chronically been getting stronger. No one's taking debt risk anymore. It's hard to have a recession when everyone's so conservative and on their best behavior, if you will. We also have a ton of liquid assets today.

[00:12:25] Historically, up until about 10 years ago, the level of total financial or total liquid assets to GDP in this country in the private sector, that is, if I take corporate liquid assets and household liquid assets to GDP, that ratio seldom was above 60%. It did get to 65% at one point. But today, we're at 75%. Never has there been so much dry powder on the sidelines.

[00:12:52] Typically, when recessions happen, the dry powder dries up, and then no one has any recourse to deal with vulnerabilities. We got a ton of it. People are pessimistic, and they're loaded with liquidity overall. And then finally, I would argue that the new era is playing a role here in creating buffers to recession in a way that people I don't think appreciate. I'll just give you one example of this.

[00:13:21] If I look at real profit per job in this country, and I plot it back to 1945, it stayed in the same range from 1945 really to 1995. Basically, for 50 years, it didn't go anywhere, up and down. Since 95, it's tripled. It's absolutely soared like no other period. I think that's because of new era technology being applied.

[00:13:49] And then, aside, they've dramatically raised the real profit productivity of labor. So what do we see going on today as a result of that? We see the economy slowing to 1% growth, and yet nobody's laying anybody off. Unemployment claims stay at very low levels. No one's laying anybody off. No one's hiring anybody, but no one's laying anybody off. Why? Because it used to be when your profit productivity didn't go up, if the economy slowed, you had to lay off workers to maintain profitability.

[00:14:20] Now, economy slows because you have profit productivity. You don't have to lay anybody off to maintain profit rates. You don't want to hire anymore, but profitability is rising relative to each job. And so I think we're seeing a buffer against what used to cause a recession. Economy slows, people lay off. With layoffs, economy slows more, and you go into recession. But we're avoiding that because of a new era.

[00:14:49] I'm just saying I think there's enough things out there that we can avoid a recession, even if the Fed doesn't ease with it. But do we really want 1% real growth and virtually no job creation? Is that what the kind of economy we want? I don't think we're going to choose. So I do think we're going to ease more aggressively, and that will broaden out this economy. One last comment.

[00:15:12] I think that one of the reasons the stock market has been so narrow is simply because we haven't brought much policy juice to it the whole time. And we're just on the cusp of maybe finally doing that. So a lot of these parts of the market that we have all given up on, heck with smalls, heck with value, we might finally decide that they are going to have their day in the sun before this is over. I'll save inflation.

[00:15:42] I think we'll get to that later. Yeah, no, that's a great overview. Clearly, there's a lot of different just cross currents happening that it's kind of hard to wrap your head around to some extent. But I think that's what we're sort of trying to do here. We'll get into charts in a second. But I wanted to just ask, so talk about like, you know, the markets rallied, I think, on Friday late last week because Powell hinted towards, you know, possible September rate cuts.

[00:16:11] So clearly they're changing their stance, becoming a little bit more dovish. Talk about that a little bit and also the other change that came out of Jackson Hole with their shift in inflation policy moving from sort of like your average inflation targeting to the symmetric 2% inflation target. So those are two kind of different things, but I think they're kind of tied to that Jackson Hole meeting of the Fed. They are.

[00:16:37] I think that, you know, the Fed to me has just been obsessed about inflation. And you start with that 2%. I personally, I think that I can't find out the emphasis of where that came from, that 2% idea. What all I can find on that is it came out during the Yellen years that they just sort of decided the 2% sounded like a good number to target.

[00:17:02] I mean, it had been around that area, you know, and I don't see any real academic research done there or even business research done. The 2% is the Nirvana rate. Uh, I, I can't find it. And in fact, I've done research historically back when I was at Wells that showed that more like 3% is a better rate to maintain to if you want to have decent growth and decent job creation profitability.

[00:17:29] But, so I'm a little suspect of that whole thing of why it became a thing and then why it's been so embraced. Like if we go away from it at all, the whole world's going to break. And yet that's kind of been the approach up until, you know, the bottom falls out of the job market. When it wasn't just you had a bad month in jobs, you found out that it's been going on for three or four months with all the revisions.

[00:17:53] Now, ADP numbers, for example, were telling us that for the last several months, but it finally came out in the one number that everyone listens to the, the payroll numbers and the big downside revisions. And it turns out that job creation is down to growing about two thirds of 1% year to date. And suddenly then, uh, the Fed just can't, they just can't ignore that. They, they might still worry about inflation, but at this point, I think they have to do something to say they're addressing the jobs work.

[00:18:24] Just on the, on the 2% cent thing, was it, is that really a significant change or not? I mean, I was thinking about the average targeting and I mean, that's not what they were doing anyway. Right. Because I mean, we've been above target for what 40 some odd months. I mean, it's not like they were going to run deflation for the next 40 some odd months to get the average back to two. So did you see that as a significant change or was that a lot of nothing? I, I don't know if it is a big change, Jack. I think that historically prior to the 2% target, the Fed just, the whole idea was let's have price, some semblance of price stability.

[00:18:53] They didn't really define that, you know, but it's kind of the idea, you know, when you see it. And that's kind of how we lived in that room. And then it became this 2% number, but you're right. Even though we've had the 2% number, we've been way above or way below, particularly since the pandemic. And now they're looking to change that where they make it even a harder rule, which I think would be a mistake. I really think that's a mistake. I don't, I'm not really a big advocate that 2% is necessarily the best.

[00:19:22] And I also think it ties your hands too much to be responsive to. I, I'd like to see us go back to just say, look, we want to promote a decent growth rate in the economy, decent job creation within the context of some semblance of price stability. And I, I don't see why right now they want to go back even tighter around it, that 2% number. A lot of what they're saying, you know, is very too, too faced right now.

[00:19:50] They're still talking up the inflation story at the same time that they're, you know, talking up how much they have to respond to employment. So I'm not sure whether they're bullish or bearish. Greenspan used to do this by just sit mumbling a lot about nothing and no one never knew what he said. And everyone was constantly confused. They do it by just talking both sides. And I guess it's basically the same result. So we shouldn't worry too much.

[00:20:18] It sounds like Greenspan's approach is what my wife would tell you that I do on a regular basis. Yeah, yeah, yeah. That's right. True for me too. As we move into the charts here, chart one gets this idea you talked about before, which is that growth has really not been that strong. So can you talk about what we see right here?

[00:20:35] Yeah, I, I just, I think, you know, we had GDP this year was way, way down in the first quarter and it was negative and it was way up in the second quarter, positive. And there was one reason for that. That was imports around the tariff thing. So in the first quarter, imports went way down in the second quarter, or excuse me, went way up in the second quarter. They came way off again to the same level. So the only way to look at how we're growing is by averaging them out.

[00:21:05] And if you do that through the mid-year, then you could see in this chart, the annualized pace of real GDP growth is a little less than 1%. Job creation through the first seven months, I believe is 65 basis points overall. And I'm sorry, I'm trying to, yeah, I'm sorry. Real GDP is slightly more. It's 1.2%. I'm sorry. Real consumption is slightly less than 1%.

[00:21:32] And I just think it's good to keep track with all the distortions in the data. It's good to keep track of where we are in terms of the general pace of real growth. I think it's around 1%. That's kind of what we're looking at here. And if you take out all the distortions, and that is not typically any spot we would live happily in the past. What do you think about this idea of the neutral read? Because one of the things I guess the Fed is trying to figure out here is are we restrictive or are we accommodative in our monetary policy?

[00:22:02] And it seems like they, depending on which person from the Fed you talk to, they have very, very different opinions of that. So, but you feel like the Fed is very tight right now based on where they are, right? I do. And I think we do have a chart on the distance of the funds rate is to the neutral rate. I think that, to me, the reasons that I think we're tight is not just about the neutral rate. That is one of them.

[00:22:31] I think it's a concern. But as I pointed out earlier, there's a lot of other reasons that I think policy are tight, too tight. But if I look at the neutral rate argument, this chart here shows the real Fed funds rate less the real neutral interest rate. The real neutral interest rate is the real rate at which you're neither – it's sort of a rate at which you can grow without inflationary consequence.

[00:23:00] Or it's a rate where you're not tightening to bring inflation down or easing to bring growth up. The problem is it is a highly theoretical rate. And everyone's got their own version of it. And this is just what I use here. But, you know, right now, the one I'm looking at here, the overall rate, I believe, is something like 80 basis points. The real neutral interest rate is just shy of 80 basis points.

[00:23:29] Now, the one that Fed may use might be a degree much higher than that, so to speak. But I think – I don't know what the correct answer is. But I think when you look back historically, even the real Fed funds rate itself is very high relative to historic standards right now. Going back historically, just leave the neutral rate out of it.

[00:23:53] If you put the neutral rate in, it's – according to this one, it's about 1% above – 1% above average right now. Now, the Fed and others would argue that look at the neutral rates really probably much higher than it was since the pandemic. And I don't think it's changed a lot. I think it's still pretty low. We took the neutral rate to very low levels there after the 2008-09 crisis.

[00:24:21] And I don't see what's really changed, that we're growing a lot faster now than we did then, which would tell me the neutral rate is still pretty low. And I think it's not a bad estimate to suggest it's around 80 basis points, which means the funds rate is still 1% above that, which is higher than 90% of the time, I think, since 1970. What is your feeling on where we are with inflation? I know you felt – and you have a great post about this – you feel like the fears of inflation are overblown.

[00:24:48] But you have heard more talk about inflation is accelerating or in the recent CPI report, which I think as a whole was not bad, people looked at the services number and said that's a really bad sign that services is picking up. What's your overall take on inflation? Yeah, I think a few different comments on – one is I think that it's okay to have some cyclical movement in the inflation rate.

[00:25:10] And I mean, I'm not going to get too excited if we go from 2.5 to 3.25 or, you know, we go 2.5 to 1.75. Who cares? I mean, that's just sort of normal. And quite frankly, the indices we use to measure inflation have at least that much error, if not more, for all we know, over time.

[00:25:34] And I think that we get – this Fed in particular, just in general, we seem to get awful excited about just little movements in the annual rates of change in inflation. You know, just to give you a example right now, the CPI inflation rate is 2.7%. I think its low was maybe 2, 3 or 4, something in this cycle. And that's down from 9.1 in 2022. And it's been falling most of the time and then flat around the same level, the mid-twos. And it's 2.7%.

[00:26:04] That is unchanged from where it was in January of 2020 before the pandemic. It is – it resided in that – at that range almost all the time between 2017 to 2019. No one was worried about runaway inflation. We seem to be today. If I look at PPI at 3.3%, it's down a half a percent from where it peaked earlier this year in January.

[00:26:33] And it's lower right now at 3.3% than it was in mid-2018. If I look at wage inflation at 3.9%, it's the same level as it was a year ago right now. It's the same as it was in mid-2021. It's about the same as it was in March of 2020, again, almost before the pandemic started.

[00:26:55] And yet the perception of these inflation rates, every little movement is like, oh, my gosh, you know, the Fed got to do this or got to do that. Where we've been – it's still around the same levels we've been at for years. If I look at commodity prices, the S&P Goldman Sachs Commodity Price Index, which is considered the leading edge of inflation force commodity prices, they pick it up first. This thing is off 35% from its peak levels in 2022.

[00:27:23] It's off 3% since year end, and it's unchanged for the last four years. Where is there a panic on inflation in that number? Let's look at inflation expectations. Look at the one-year break-even rate, which is the embedded inflation forecast of bond investors one year forward from now, taken from bond date. And that number right now is 2.7%, exactly equal to the current inflation rate.

[00:27:51] So what that is saying is bond investors expect the one-year forward inflation rate to be exactly what it is today. Okay? If I look – and this, by the way, has been unchanged since year end. That is to say, before the tariff thing with Trump, it's at the same level as it is today as at year end, the forward one-year number.

[00:28:12] If I look at the New York Fed's one-year median inflation survey among consumers, that thing's at 3%, and that's unchanged since two years ago in 2023, and it's equal to where it was in 2018, and it's unchanged this year.

[00:28:30] I just – when I look at those numbers, I just don't – they don't jive with the hand-wringing and noise I hear in the media and everything about every little inflationary uptick and downtick. I don't have the exact dates, but I know inflation, the CPI inflation rate back in like 17 or 15, a couple different times, went from like 2% to over 4%, went to 2% over 4%, and then came back down again.

[00:28:58] And over that period of time, no one was too concerned about it. And yet today, we're growing more slowly in real terms, and yet inflation doesn't seem any more, I guess, worse to me than a lot of the others. As far as tariffs are concerned, yeah, there's going to be reports of increases in product prices, no doubt about it. Your favorite bubble gum is going to probably go up in price or something. There'll be reports of that. I no doubt about it.

[00:29:25] But we're concerned not about individual product pricing. We're concerned about the aggregate inflation rate. And I think there's a good shot that the follow-through of these tariffs aren't going to be that great. You've got to remember that 80% of the economy now in the United States in GDP terms and employment terms are service-based industries, the great bulk of which do not have direct tariff impact.

[00:29:49] Now, for them, service sector inflation is still decelerating here over the time. The latest report, it's still kind of coming down. Maybe a modest pickup. And there's all kinds of different things they break down, you know, services without rent, services without energy. They all kind of show a similar pattern. Have they picked up a little bit? Yes. But are they really picked up much at all? No.

[00:30:12] And I think that with 1% growth in the economy, 2% growth in employment and higher product prices for a lot of the 20% of the economy that is tariff-related, those guys hire service companies. You know, the auto manufacturers hire accountants and consultants and lawyers. And guess what?

[00:30:38] If they have to, they suffer a loss of business because they have to raise prices, guess what? They're going to hire less services. Guess what's going to happen? Service sector pricing is going to go even more weaker. And I still think that that's going to happen. Could inflation go from 2.7 to 3.25? Yeah. But so what? Is kind of my point. The real question you've got to ask yourself to me is, is there a secular inflationary force here that we've got to worry about?

[00:31:06] Where inflation could get out of control for several years? And I don't think there is. I mean, I won't go into a great deal of it, but our demographics in this country are lousy. That's why inflation has been so low for years. In the 1970s, labor force grew 2.5% a year. Really, in the last several decades now, it's been growing 1% a year. And if you don't have near the growth going on, inflation just can't take off. You look at competition.

[00:31:37] Trade in the United States today is 2.5 times greater as a percent of GDP than it was in the 1970s. We are so much more fully exposed to competition than we ever were in the closed economy of the 70s. We have, as I mentioned earlier, much lower debt usage than we ever have used, which is an inflationary fuel, if you will, which is going the other way. It's an extinguisher, if you will, today.

[00:32:02] Inflation expectations are notably less today, in part because we've had four decades of low inflation. I grew up in the 1970s, and I remember just expecting that school clothes every year would be higher than they were before. Sticker prices went up every year. Everything chronically got more expensive. No, I don't expect that nearly as much anymore.

[00:32:21] And then you have the tech sector, which is a serial disinflationary generator, chronically where sticker prices in tech go down every year as power goes up every year. Back in the 60s and 70s, we had automobiles as our leading industry, and the sticker prices went up every year, and everyone else followed suit. I don't see secular inflationary force. I see the opposite.

[00:32:47] But the biggest one is policy, and that's Milton Friedman. I think we might have charts of that. Milton Friedman talked about inflation is always and everywhere a monetary phenomenon. He said that four decades ago or more. He's been dead for a while now, too, but it's still true today that inflation needs monetary growth. That's something we have not had.

[00:33:11] Just published this to try to bring a sense about the fuel for inflation just doesn't exist today. The top chart there, the blue line is, or let me go with the red line, is the level of the M2 money supply divided by GDP. Now, why is that important? Because when that goes up, it says that there's excess liquidity above that needed by the economy being generated. So the economy uses a big chunk of that to finance its growth rate.

[00:33:40] But then if there's more than that, guess what? That goes into assets, financial as well as non-financial assets driving up inflation. When that ratio comes down, the opposite is happening. There's not enough liquidity even to maintain the growth rate of the economy, and it's pulling liquidity away from inflationary demand. Okay, so that's a measure of inflationary force. The blue line in that chart is what I would call cash dumping or cash hoarding.

[00:34:07] Now, this one is not sanctioned by the official CFA guide or anything or the Econ 101, but I think it's real. And what this ratio is, it takes all of the liquid assets among corporations and households relative to their total asset holdings. And when the blue line goes up, it says that the private sector is hoarding more of their assets in cash. If the blue line goes down, it says they're spending more of their cash.

[00:34:37] Okay? So that you could see is a disinflationary inflationary force. If I take the red line and divide it by the blue line, I'm taking excess liquidity divided by cash hoarding. So if you get a situation where excess liquidity is coming down and cash hoarding is going up, that's a very disinflationary force. And I'll show you what that looks like in the next chart. And the blue line in this chart is annual CPI inflation.

[00:35:03] And the red line is that ratio, liquidity indicator ratio, which is a ratio of excess liquidity above economic growth divided by cash hoarding, if you will. And you can see that not only historically has there been a very good relationship between these two. In fact, when that red line's been coming down, you've never had any real lasting inflation problem. You just haven't.

[00:35:31] You have when it's gone up at different times, but you haven't when it's come down. The last inflation problem we had, it's no surprise to me, it came after that red line was going up for years and inflation wasn't. And then it exploded, it helped probably explode that inflation cycle. But right now, this indicator is saying that there's no monetary juice for inflation to sustain or runaway inflation. In fact, it's going the other way. It's saying inflation maybe goes lower in the next few years.

[00:35:59] So in this next chart, we're getting at this idea of the inflation surprise index. So some people might not be familiar with what that is. Can you explain what that is and what you think it means? Yeah, I can. I put this out. This is not a super important chart, but it's one that's done a pretty good job of leading the inflation rate. The blue line here is the annual CPI inflation rate. The red line is the Citigroup Economic Surprise Index just for inflation reports. And so all they're doing every week as inflation, every month as inflation reports come out,

[00:36:28] is they look at what the report was relative to what the market expected on that report. And if reports are coming out ahead of expectations is rising and below expectations fully. I think that expectations are very much a momentum thing. We get into situations where people have a view and then things start to surprise them because reports are actually strengthening faster than they expected.

[00:36:53] And so I think the red line is a great measure of inflation momentum in the economy. And you can see that it tends to lead actual inflation. So the red line goes up before the blue line did. It came down before the blue line did. And right now it's suggesting that momentum and inflation is downward, not upward, as so many people seem to think. It might be wrong, but it's been a pretty good signal in the past. So as we move to the stock market, I put this chart in because I thought it was a really interesting chart.

[00:37:23] You were looking at things that are key supports of the stock market. And you were kind of looking at the situation with them and sort of where we are now. So can you talk about this? Yeah, just one of the things I'm interested in, you know, is we talked about earlier a little bit and people realize this has been a very narrow bull lurk that is just going to start its fourth year. And it's been about an average bull over its first three years as far as S&P returns.

[00:37:50] But if you go outside the S&P, it's been way below average in terms of its performance as well as its participation. I would argue that one of the big reasons for that is we haven't given it a lot of the supports that a bull market has historically generally had. And these are just a number of them. Most of these on this chart, except for the inflation one, maybe, have not yet been used in this bull.

[00:38:19] The one on the left, I'm looking back all the way back to 1960 at these. And I say, how is the stock market done every month when money supply, annual money growth goes up versus when it goes down? And you can see it's a wild, wild difference in terms of the impact on stocks. All the months when liquidity growth improves, stock market S&P has done 12.7% annualized versus only 2.2% those months when it falls year on year. And I did the same thing for these other ones.

[00:38:49] The Fed funds rate, when it goes down in this case, it's supportive when it goes down. And when it goes up, which the red line is not supportive, that in the bond market, you can see very similar in terms of their positive impact for stocks, falling yields versus rising yields. The dollar, I don't think people appreciate just how powerful a force it is.

[00:39:10] When the dollar goes down, stocks have done 22.8% annualized across all months that it fell, in this case since 1970. And it's only done 1.7% when the dollar's going up. CPI is helpful when the CPI falls. It does better than when it goes up, but not by a great amount, but some. And then finally, consumer confidence. Of course, we do much better during months of rising confidence than we do with falling confidence.

[00:39:39] Now, the reason this is so important is because, I would argue, because the Fed has remained contractionary almost throughout this entire bull market, it's only eased the funds rate three months. And that is the smallest amount of easing by any bull market cycle in post-war history that I've found. That when you hold the funds rate up and hold money growth down, you keep all of these things that normally help the stock market and the economy do well on the shelf.

[00:40:08] And that's exactly what I think we've done. And I would argue that that's why it's been a relatively disappointing stock bull in terms of participation is because so many of the positive supports haven't been used. The good news is we might be on the cusp of starting to use these. If the Fed eases funds rate, you can look at that chart, what that would mean. If they drop the funds rate, bond yields will be able to go down. That'll help.

[00:40:37] Money supply starts to go up fast. That'll help. And finally, if you finally have a Federal Reserve that comes out and tells the country, we are going to support this economy, we are going to support the financial market. Guess what? Confidence finally rises in this country, maybe for the first time. And if you put all those together, that is quite a powerful force coming at your stock portfolio. And I think we just haven't had it yet. It's possible that we might be finally getting it.

[00:41:07] We'll see. And what's on the last point about confidence, I mean, that's something we've talked about in previous episodes is confidence has been surprisingly low. Given everything that's been going on in the stock market being up, like confidence hasn't come in at all really yet, right? Or maybe a little bit. Nope. It's still laying right down there at some of those lowest levels in poster history. And I think coming up, we're going to talk just a little more and I'll relate it back to that a little bit of why confidence has been so punk. One of the things I see you use a lot is you use like you're looking at things against their trend line.

[00:41:34] So it seems like that's something you're, you know, as we work with you on this show, it's something you feel you're a pretty strong believer in. And this is looking at the S&P as a percent above its trend line going back. Yeah, I like trend line analysis. Only because it smooths out short-term distortions in the data.

[00:41:54] When you value the stock market and you use the trailing 12-month data or the future 12-month earnings data or whatever, that's subject to a lot of potential ups or downs just depending on the day you're doing it. You know, if you're in the middle of a recession and earnings are going away at all your cyclical stocks, how can you use that to judge where their value is if earnings go negative or if earnings just fall off the map? Or if you get into a boom and your value gets boom earnings, that's not good either.

[00:42:23] But the thing about trend line is in this case, I'm looking at the price of the stock market today compared to its long-term, multi-decade, normal level. And that would be, in this case, looking at its trend line average going back 80 years, essentially, from 1945 to 1995 or 2025 and saying, where is it relative to its average rate?

[00:42:51] Its average rate of growth over, I think, over that period of time is around 8% a year or something like that. And so if you've had several years where it's doing much better than that and it's way above that average level, that really tells you something. It tells you about valuation risk, I think, in the market. Or if it's a lot lower, it tells you opportunities. And so this chart looks at the detrended S&P 500 against that 80-year trend line average.

[00:43:18] And clearly, you can see the lows here on this chart are great times to buy. They represent market lows, historic proportions. And I've labeled a lot of the highs there on the chart, which you can see are very bad times to buy. And we're sitting at one right now in the S&P 500. This S&P 500 is sitting at, you know, a very high level above its trend line average,

[00:43:44] sitting above, by around maybe about 50% above trend line right now, which is the only time it's really been worse than that in any big way was the dot-com top. So S&P 500 does look very, very expensive on this basis. But one of the reasons I looked at this this time was because if I dig down a little deeper to the broader marketplace,

[00:44:07] what I find is while the S&P is really very, you know, expensively or extended, if you will, relative to the trend line, much of the rest of the stock market is not. It's almost in the opposite position. So what I looked at in this table is I went back to 1945 with the French data, which has a whole bunch of different sectors. And I used 12 of their major stock market sectors going back to that time period.

[00:44:35] And I looked at every bull market we've had over that period of time. And the date starting in 46, 56. December 21 was our latest, the last one. And then today's bull market, which started in October of 2022. And I said, how did, how, how did at that point when the, when the bull was going, how, how did, or during that bull market,

[00:45:03] how, how did each of these sectors look in terms of where they were relative to their trend line averages? Were they way above trend line? Were they way below trend line? And you can see what the different sectors were at every point in time. I'll draw your attention just to the lower two lines. The second from the bottom, I look at every one of them and said, at that point in time, when the, when those bulls began,

[00:45:29] what was the number of the sectors of the 12 sectors that were above their trend line average? And you could see that in May of 46, nine of the sectors were above average. July of 56, nine. Then there was 12, nine, 10, 11, 11, 10. In today's bull, there's only seven of the 12 sectors that are currently above trend line average. A far cry difference. If I look at the bottom line, it looks at the, across all those 12 sectors,

[00:45:58] what is the average sectors above or below trend line percentage? And in May of 46, almost 40%, the average extension of the trend line when that bull started was 40% above trend line. In July of 56, it was 28.9% and so forth. Today, the average, today is only, the average sector is only 15% above trend line right now.

[00:46:27] So I just think it shows how much, while the S&P 500 is expensive, okay, much of the rest of the market is not. And as you can see, historically, that's an uncommon result of being in this position right now. This just kind of graphically shows what I was talking about. Just one example. The blue line here is large company cap growth, and it looks at its de-trended, since the 1845 level of large cap growth in this country.

[00:46:55] And it is really extended up around 80% right now, slightly less than where it was in dot-com, but close. But what's interesting is two other, you know, popular styles over time, value, which is shown in green, and momentum, which is shown in red, are both below trend line, okay? And that's very odd, because if you look at the dot-com era in the 90s, all three were above trend line. If you look in the 60s when the market peaked, all three were above trend line.

[00:47:22] We have a market which is very expensive among large cap darling S&P stocks, but is still pretty cheap among a lot of the rest of them. So in this next chart, we're looking at the trailing 12-month EPS of the Russell against the S&P 500, and you've got a pretty massive divergence here at the end. So what are we seeing here? In a recent piece, Jack, looked at, I got thinking that I think what's going on is that normally, historically,

[00:47:49] all companies, of all ilks kind of go up and down with the economic cycle over time. Large cap, small cap, cyclicals, defensives. When you get into a recession, everyone's hurting. When you come out, everyone's at least growing, right? But I think in 2022, I think what happened is small companies and a lot of other companies probably went into recession and have never really come out.

[00:48:15] But large companies didn't even go into recession, and then they soared ever since. And so we've had this dichotomy of a wide chasm of difference between a big chunk of the economy, which recessed, and one that just kept booming. And I think that best describes what we've been through in the last few years.

[00:48:36] This chart, the red line is S&P 500 trailing EPS, and the blue line is Russell 2000 EPS. And you can see in the dot-com recession, they were very similar. In the great financial recession, they're very similar. In the pandemic recession, they're very similar. But boy, look at 2022. 2022, S&P 500 earnings sort of paused for a moment, but then they took off.

[00:49:05] Russell earnings died and stayed dead ever since. I think that the Fed didn't help this dichotomy because when we got into 2022, they looked at large company stocks and large companies, and they were all doing fantastically. So why should they ease? And I think they didn't. They kept tightening. But here was all this vast array of other companies, mostly small caps, mid caps, but others, that were fighting in a recession.

[00:49:33] And the whole time, they've been having their policy officials tightening on top of that, which is just might be a unique situation here for much of the post-war here. I don't think we've had a lot of companies in recession with policy officials tightening on top of them because we've never had a big divergence like this. And it must have really seemed, this explains a lot to me. If you look at CEO confidence, which is mainly confidence measures among the largest companies in this country,

[00:50:03] they came down a little bit for a while and went back up. They stayed closer to expansion levels. But if you look at the small business institutes, SBOI, Small Business Optimism Index, it collapsed and really has never recovered. Why are consumers feeling so bad about life over the last few years while large company stocks go to the moon? Well, I think it's because a lot of them work for these small companies that are doing well.

[00:50:33] And meanwhile, we continue to tighten on a big chunk of the economy that's done poorly because we're watching the large guys that are doing so well. Why is large done well when nothing else has? Well, I think my guess is simply that this is made up disproportionately now in market cap terms by companies that have divorced themselves from the economic cycle in many ways. They really have.

[00:50:59] Their growth is determined by innovative capital spending driving their marketplaces, not by the cyclicality up and down of the economy. So we, again, the new era might have created this dichotomy we've not had before for the first time because these companies have kind of divorced themselves in a bigger way from the cycle. Doesn't mean they won't go down at some point because they got their own cycle going, innovation cycles come and go.

[00:51:25] But it does mean that while the old cycle is still in force, they're no longer necessarily linked like they used to be. Another chart that shows this is the next one, Jack, which looks at the detrended level of U.S. corporate profits, which is the blue line. Another detrended series to your point earlier about me using trend a lot.

[00:51:49] And the red line is the detrended level of S&P 500 profits. Now, look at this chart up until about 2022. They almost always were either above trend line or below trend line all at the same time. Now, I must say for readers, I've not published this chart officially yet, so you're getting a freebie here today. But I will do more on this. But my point is, you can see everything kind of moved together.

[00:52:19] We never had a situation where some companies were had below average profitability, while others had way above average for the most part on aggregate measures. But boy, have we had that now. S&P profits are running about 20% above trend line, while corporate profits broadly, including those, by the way, of large companies, are down 10%. If you excluded those large company earnings from the measure, it'd probably even be worse of a dichotomy.

[00:52:48] And I do think that this says a lot about where we're at in a manner that no one else that I've seen are really talking about. No policy official, no government official, not many people on Wall Street that I haven't seen anybody. But this is a heck of an issue that needs something done to it. And it would explain maybe why much of this country feels so bad about the future, because it feels that things are really bad when this one big chunk of popular companies is doing so well.

[00:53:18] I think it's because we've left a big chunk of the economy essentially in recession, and then we added insult to injury by tightening on top of a recession. And if the Fed finally starts to ease, I think there's a lot of profit leverage here, a lot for a lot of companies. This top group, big companies might not do much, but boy, there's a lot of profit leverage for a lot of other companies. And if they do more, think what the leverage could be for their stock prices as well.

[00:53:48] That was going to be my question. I was going to ask about when the Fed does ease, do you think that does most of what needs to be done to resolve this? Or do you think there's other things behind the scenes that are also major issues that have to be dealt with beyond just the Fed ease? Well, it's a good point, Jack. I think it's mostly Fed ease because Fed ease is holding up a lot of other things. I think the lack of Fed ease is keeping the dollar stronger than it should be. It's keeping the yield curve more inverted than it should be. It's keeping money growth much less than it should be.

[00:54:17] And it's keeping confidence much lower than it should be. But it's not the only factor. I mean, we still have far too much volatility in the world for companies to plan and to make decisions. And when you increase volatility, you depress animal spirit behavior. You depress risk taking. And I'm not even talking about the stock market. I'm talking about in companies that want to expand their employment, their facilities and the like.

[00:54:44] It's hard to do that when you're so unsure about what the next change is going to be out of Washington or whether the impact of wars, the geopolitical events could have on us and so forth. So there's still some of that that's going to be there. But I'll tell you, a lot of it could change just by the Fed easing, I think, because it would bring so much more of those supports that we showed earlier to play that I think would help the blue line aggregate profits in a bigger way.

[00:55:13] And then, you know, by proxy also helped a big part of the stock market. And it's almost I think almost to like. Investors have been so because the S&P has done so well, like behaviorally investors are so conditioned to invest in the S&P 500, invest in the mag seven, that when you see this profit reversion start, you know, it's like some investors may not like believe it's happening because the last 15 years we haven't really seen it.

[00:55:41] So it could take some time to sort of just ease or eek in or leak into like the investor mindset that there is actually an opportunity here with some of these smaller, you know, small mid cap names. It's a good point, Justin. That's an excellent point. It might. It might well. I mean, think about think about how long it took investors to embrace the 1980s bull. You guys are probably too young to remember.

[00:56:09] But, you know, we had after the great inflation of the 70s and 21 percent prime rates and destruction that occurred from all that, the bull market took off in August of 82 and went straight north. And there was no one, no one at that point that thought that thing would last. And I don't even think they really did until the 1987. Right. And everyone got in right when it crashed. But my point is, it's somewhat to that.

[00:56:37] When you have long periods of this opposite, it takes a while for people to think it's going to be nothing more than a flash of the pan. And they stick with their old. But it does. It's interesting to think about how much do you think portfolios are so overexposed to the red line in this chart and have so little exposure to the blue line. That is to say, we've all been so successful in our S&P 500 investments.

[00:57:06] And as a result, every year we crept a little more towards them because our smalls weren't doing what we thought. Our sickles weren't doing what they thought. Our health care wasn't doing what they thought. And as a result, we're probably way underweighted much of the rest of the market relative to that. So not only could there be, it might take a while, but the amount of leverage here in terms of what could happen if people do finally convert could be pretty impressive.

[00:57:35] And it may, you know, at a minimum, just elongate this bull much, much more than you think about at this point in the cycle, so to speak. Right. So just one other follow-up on that. I look at a lot of 13F filings of firm, both, you know, investment firms, but also wealth managers and advisors. And it does surprise me when I go into these, and maybe it shouldn't, when I go into like these, you know, multi-billion dollar wealth manager 13Fs. I mean, they're loaded up on this stuff too. They're loaded up on the MAG-7.

[00:58:03] I mean, those stocks have done really well, but it's not just like the retail investor. It's like- It's not. You know? So anyways. They have a, Jesse, you're exactly right. They have an ETF. I think it's called BBIST is its symbol, but it's a billionaire, billionaire holding ETF. And somehow they gather the data on what billionaires are holding, and that's what's traded in this thing. And it is so highly correlated to the MAG-7 right now.

[00:58:33] It's not even funny. So it's not just the naive, what is a dumb money investor that's sitting overly concentrated. We all are. We all are. I mean, I probably am too. I mean, it's just hard to come out when they keep doing so well. And we'll all get burned a little on it. And the other thing that happens, because I can tell you this is a stretch, is that, you know, how many times has all of us recommended small cap stocks at some point over the last few years? And then been wrong.

[00:59:03] And at some point, you just quit talking about it. I'm probably a little guilty of that too. And that's the kind of thing that happens. And that's what sets up great opportunities and or on the other side, great risk in the market. It plays out that way over and over again. So we'll see you again next month, Jim. But in the meantime, what are the most important things you're kind of going to be paying attention to here as we sort of come out of summer, coming to the end of the year? Well, I tell you the truth.

[00:59:32] I try not to get myself too short term oriented a lot. I do, though, just like everybody else. You know, I'm still a little worried about the seasonalities that people talk about. It's not a great period of time yet, at least until you get to October. So you certainly could have a pullback. But, you know, I think we had one 20% pullback this year already. So that's pretty good, pretty good pullback. We might just breathe right, breeze right through that. But I'm going to be mostly looking at, you know, is the Fed going to follow through here?

[01:00:03] And try to set off a new policy regime, in essence. They're not going to call it that. But I will they set off something new that will broaden out this market. And I'm watching right now when the broadening that's kind of occurring here. You know, small cap stocks have been market performers now, I think, since about April. And market to them. And if you look at the two days, great examples.

[01:00:27] The one was when the jobs number came out that was so far worse than anyone expected. It instantly caused people to think the Fed was going to ease. And the second day was the Jackson Hole speech. When those two days, the relative performance of small caps were just outstanding. I mean, they were outperforming leaps and bounds. They were up like three to four percent on each of those days nominally and, you know, double to triple what the S&P did.

[01:00:55] That gives you some sense of what could happen if they follow through. But we can't we can't just have the situation where the Fed maybe does 25 and then we get another, you know, one tick, two tick hot CPI report and they decide to keep, you know, pause again or something. I don't know. So I'm looking at a sort of sustained change in policy or not, I guess is what I'm kind of looking at between now and the end of the year. All right, Jim, thank you very much. We will see you at the end of September. We really appreciate it.

[01:01:25] You bet. Thanks for having me, guys, as always. Appreciate it. Thank you for tuning into this episode. If you found this discussion interesting and valuable, please subscribe on your favorite audio platform or on YouTube. You can also follow all the podcasts in the XS Returns Network at xsreturnspod.com. If you have any feedback or questions, you can contact us at xsreturnspod at gmail.com. No information on this podcast should be construed as investment advice. Securities discussed in the podcast may be holdings of the firms of the hosts or their clients.

[01:01:55] Thank you.