PerspectiveEconomic and MarketBringing you national and global economic trends for more than 30 years

Wells Capital Management

September 17, 2015

A Leadership Change?

James W. Paulsen, Ph.D

Chief Investment Strategist,

Wells Capital Management, Inc.

Most investors are understandably focused on whether the

Federal Reserve will raise interest rates today and what this

may imply for the recent stock market correction. However,

underlying recent ! nancial market volatility and this Fed drama

is perhaps marking a major change in stock market leadership.

We believe commodity prices are in the process of bottoming

after trending lower during the last four years of this recovery.

The current stock market correction and the ! rst Fed hike in

interest rates may be marking an important shift in economic

pricing power from consumer prices to lower stage industrial

prices. A shift in economic pricing power from consumers to

producers has traditionally altered stock market leadership

away from domestic toward international stocks and from

consumer to industrial stocks.

Are commodity prices bottoming?As we examined in an earlier research note (see the Economic

and Market Perspective from August 25, 2015), a signi! cant

collapse in commodity prices during the middle of an

economic recovery is actually quite common. Chart 1 shows

the S&P GSCI Spot Commodity Price Index since 1970. The

collapse in commodity prices since last summer is similar to

past recoveries and like then, it does not suggest economic

growth is about to slow.

Chart 1 S&P GSCI Spot Commodity Price Index

Natural log scale

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Economic and Market Perspective | September 17, 2015

In three of the last four recoveries (i.e., the late-1970s, 1980s

and 1990s recoveries), commodity prices su! ered a severe

decline “during” an ongoing economic recovery. In each of

these cases, the economic recovery persisted well beyond

the bottom in commodity prices. Indeed, in the past, once

commodity prices bottomed, the pace of economic growth

accelerated and the recovery did not end until commodity

prices had substantially recovered. For example, in the late-

1970s recovery, commodity prices bottomed in July 1977

and the recovery did not end until January 1980. Similarly,

commodity prices bottomed in July 1986 but the economic

recovery continued until July 1990. Finally, commodity prices

bottomed in early 1999 but the recovery did not peak until

March 2001. As shown, a signi" cant decline in commodity

prices usually points to stronger rather than weaker future

economic growth. Moreover, once commodity prices do

" nally bottom, they have typically risen throughout the

balance of the economic recovery.

Although most believe oil prices (and overall commodity

prices) are continuing to collapse, chart 2 suggest they have

been in a bottoming process since early this year. While the

spot price of WTI crude oil did collapse last year, it is currently

about $45, a level it " rst reached in mid-January. We suspect

the commodity markets are about to embark on a multi-year

advance which will likely alter leadership in the economy and

in the stock market.

Economic pricing powerStock market leadership is often concentrated among

companies possessing economic pricing power. Chart 3

examines the pricing power between two major segments

of the U.S. economy – the consumer and the producer. The

core crude producer price index tends to move similarly with

overall broad-based commodity prices. Similar to the S&P GSCI

commodity price index, the core crude producer price index

has declined since the summer of 2011 and su! ered a major

collapse during the second half of last year. Not surprisingly,

core crude producer prices are much more volatile compared

to consumer prices. Consequently, economic pricing power

tends to shift between producers and consumers as commodity

prices rise and fall.

WTI crude oil spot price

Chart 2

Chart 3

Core consumer prices vs. core crude producer prices

Natural log scale

Solid: Core Consumer Price Index

Dotted: Core Crude Producer Price Index

(crude non food materials less energy)

| 3 |

Economic and Market Perspective | September 17, 2015

Consumer companies have enjoyed strong relative product

pricing since 2011 (primarily because producer pricing has

been so weak) but this prolonged trend may soon change if

low stage producer prices are bottoming. If economic pricing

power does change, investors should also anticipate that stock

market leadership might experience a transformation.

New stock market leadership?Charts 4 and 5 illustrate two major stock market trends likely

to undergo leadership changes should commodity prices soon

bottom.

The dotted line in both charts represents the economic pricing

power of consumer companies relative to producer companies.

It is a ratio of the core consumer price index relative to the

core crude producer price index. Chart 4 compares economic

pricing power (dotted line) with the total return performance

of the U.S. stock market relative to international stocks (solid

line). While not a perfect relationship, changes in economic

pricing power have been highly correlated with the relative

performance of domestic versus international stock market

returns. U.S. stocks tend to outpace foreign stocks when

consumer pricing power dominates producer prices. Most

likely, this is because the U.S. economy is more consumer

centric compared to foreign economies. By contrast,

international stock returns typically outpace U.S. returns during

periods of relatively strong producer pricing trends. As shown,

consumer prices have been outpacing producer prices for most

of the last four years and U.S. stocks have dominated global

returns during this time. However, if commodity prices soon

begin to rise again, stock investors may want to increase foreign

market allocations.

U.S. / ex-U.S. total return stock performance vs. CPI/PPI

Ratio

Dotted (right natural log scale): Ratio of Core Consumer Price Index

divided by Core PPI Index for crude non food materials less energy

Solid (left natural log scale): MSCI relative total stock market retrun :

U.S. stock market vs. global ex-U.S. stock market in U.S. dollars

Chart 4

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Economic and Market Perspective | September 17, 2015

SummaryThe current Fed drama may be signaling more than simply

a stock market correction. We believe commodity prices are

nearing a bottom and expect that economic pricing power will

soon switch from consumer to industrial companies for the

balance of this recovery. Consequently, stock investors should

consider boosting allocations toward industrial and producer

stock sectors and reducing exposure to the U.S. stock market in

favor of foreign equities.

Written by James W. Paulsen, Ph.D.

An investment management industry professional since 1983, Jim is

nationally recognized for his views on the economy and frequently

appears on several CNBC and Bloomberg Television programs, including

regular appearances as a guest host on CNBC. BusinessWeek named him

Top Economic Forecaster, and BondWeek twice named him Interest Rate

Forecaster of the Year. For more than 30 years, Jim has published his

own commentary assessing economic and market trends through his

newsletter, Economic and Market Perspective, which was named one of

“101 Things Every Investor Should Know” by Money magazine.

Chart 5 illustrates an even closer historic relationship between

consumer/producer relative economic pricing power and

the relative total return performance between consumer and

industrial stock sectors. So far in this recovery, economic

pricing has persistently favored consumer companies and

most consumer stock sectors (e.g., the S&P 500 consumer

discretionary sector). Nonetheless, should commodity prices

soon bottom; stock market leadership in the balance of this

recovery may be concentrated among the industrial stock

sectors.

Chart 5

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Consumer / industrial total return stock performance vs.

CPI/PPI Ratio

Dotted (right natural log scale): Ratio of Core Consumer Price Index

divided by Core PPI Index for crude non foodmaterials less energy

Solid (left natural log scale): Relative total return performance of

consumer sectors vs. industrial sectors. Data from Kenneth French

12 sector U.S. universe. Consumer sectors include consumer non

durables, consumer durables, telecom, utilities and shops (retails).

Industrial sectors include manufacturing, energy and chemicals.

Sectors are equal weighted.