To hear Jim Paulsen tell it, the market meltdown that rocked stocks last week was a long time coming.
And to make matters even more frustrating, he says the warning signs were there.
Paulsen, the chief investment strategist at Leuthold Group, is specifically referring to the “overheat pressure” that he sees building in the economy. That pressure then, in turn, afflicts the stock market. And it hinges largely on both price inflation and wage growth— two measures that have been ticking higher after an extended period of dormancy.
While that combination has been toxic to stocks in the past, investors don’t seem to have learned their lesson. For that reason, “overheat pressure” has lurked as a hidden threat to the market — one that now appears primed to start wreaking havoc once again.
“A common view that inflation and yields remain quite low and do not represent much of a threat for the stock market is simply incorrect,” Paulsen wrote in a client note. “Because both wage and price inflation recently reached new recovery highs, overheat pressure seems poised to become even more pronounced.”
Paulsen highlights what he calls an “overheat round” that started punishing stocks back in 2015 and continued through the end of 2016. He notes that during that period, wage and core consumer price inflation accelerated.
And wouldn’t you know it, stocks were whipsawed for much of the two-year span, which saw them absorb multiple sharp drawdowns. This can be seen in the first highlighted section below. The chart also suggests we could be in the middle of a second overheating round right now.
As if that isn’t worrisome enough, Paulsen warns that market conditions are coalescing in a way that could worsen the effects of overheating economic conditions.
He’s particularly focused on the correlation between stock prices and bond yields. Conventional wisdom would suggest that the prices of either asset should trade inversely to the other. If someone exits a stock position, there’s a high likelihood that the person is rotating into bonds, and vice versa.
But this historical relationship has broken down. Prices of both stocks and bonds were in free fall for much of the past week. And to make matters even worse, it was spiking yields— which reflect declining bond prices — that have helped stoke so much anxiety in the equity market.
As indicated by the chart below, stocks and bonds have been negatively correlated on just a few occasions in the past 20 years. And each prior instance has been accompanied by widespread stock selling.
Paulsen says this relationship represents a “toggle switch which has historically magnified the negative impact of overheat pressure.”
In case you were considering ignoring these warnings signs, the mini market meltdown from last week should’ve grabbed your attention. It not-so-coincidentally ran parallel to the newly negative correlation between stocks and bonds outlined above.
That’s at least partially because investors were unable to rotate out of stocks and into the safer confines of bonds — a long-running hedging technique when normal conditions are in place. Instead, there was no place to hide, and traders got battered.
Going forward, investors would be best advised to keep a close eye on the two economic indicators that inform Paulsen’s thesis of an overheating economy: price and wage inflation.
As long as they’re rapidly growing in tandem, markets will be in a highly vulnerable position.
“Concerns about inflation are perhaps rising more quickly than recognized,” said Paulsen. “Wall Street’s overheat mindset appears to be on the cusp of greater anxiety.”