This column originally appeared on Real Money Pro at 9:00 a.m. EDT on March 27.NEW YORK ( Real Money) --
"Whoever fights monsters should see to it that in the process he does not become a monster. And if you gaze long enough into an abyss, the abyss will gaze back into you." -- Friedrich NietzscheYesterday, my friend/buddy/pal Wells Capital Management's Jim Paulsen made the case on CNBC's "Squawk Box" that the Fed is holding back market prices and valuations by maintaining artificially low interest rates. Jim opined that if the Fed abandoned quantitative easing and allowed interest rates to rise (even appreciably), market valuations would move meaningfully higher. To Jim, the 1970s, 1980s and 1990s represented a distinct period when inflation was elevated and yields were almost always above 6% -- P/E ratios suffered. By contrast, Jim observed that the 1950s and 1960s represented time frames when interest rates started low (well below 6%) and rose -- valuations increased as well, rising to nearly 20x. Jim sees the inevitable rise (second half of 2013?) in interest rates (from very low levels) and a possible Fed exit as signals of an improving economy that will reinforce his case for better market valuations later in the year. Here is the tape of Jim's appearance on CNBC yesterday -- it includes not only his variant view on the relationship between interest rates and stocks but it includes a lot of interesting historical data to support his analysis. Let me start by framing this morning's opening missive with my constructive and deferential view of Jim's body of work. Jim and I are very much mirror images, and we rarely agree. In some ways, our differences are similar to my sometimes at-odds market outlook vs. Jim Cramer. (I sometimes jokingly refer to myself the Anti-Cramer.) Similar to Jimmy C., Jimmy P. has historically viewed the domestic economy and the U.S. stock market as a glass half-full, while I have viewed (especially over the past 18 months) that glass as being half-empty. Since the mid-2000s, Jim Paulsen and I have debated the market and domestic economy's prospects on "Squawk Box," "Street Signs" and frequently on "The Kudlow Report." It is important to note that recently, in those debates, Jim has been materially correct in view while I have been wrong-footed. I routinely receive Jim's research, and what I like most about it is that he backs up his conclusions with hard-hitting facts and analysis. I have even asked him for permission, in the past, to use his supporting charts in order to lend credence to some of my investment and economic conclusions and analyses.
Most importantly, what I admire most about Jim is that he does not deliver the standard bullish Pablum and glittering generalities. Rather, he is very good in looking at different angles that the perma-bull crowd ignores generally because of lack of imagination or creativity of analysis or just plain sticking to dogma. (As Joe Kernen remarked yesterday, Jim "thinks outside of the box.") There is a broader lesson here that goes beyond our differences. Based on our frequent exchanges, it appears to me that Jim respects my views (as I do his) -- again, even when we disagree. When our views are invariably different, we bang it out back-and-forth in our debates -- just like Jim Cramer and I do. Our exchanges are not like the boorish attitude of the arrogant and self-assured that we often see on Twitter and elsewhere in the blogosphere. Rather, our debates on ideas are always courteous and productive. Though we rarely change each other's opinion, we have a mutual respect. There is never an air of superiority or an overbearing tilt nor is there an arrogance of view or boorish attitude toward each other. (Too often public debate is reduced to veiled personal name-calling and a polemic filled with sound bites that fail to deliver a constructive end that is useful to anyone in their decision-making investment process.) Healthy and respectful debates, similar to those that the Jims and I have had in the past, are desirable, stimulating and make us better investors and analysts. We force each other to consider the alternative argument/outcome in our analysis.
It's Different This Time
"Some people never change, and it's fools like me who believe this time will be different." -- AnonymousLet's now examine where I disagree with Jim Paulsen's views expressed on CNBC's "Squawk Box." History might rhyme, but the domestic economy (and for that matter the global economy) is in a much different place in 2013 compared to the previous time frames that Jim has examined. Specifically, the U.S. economy is far more fragile and dependent upon the policy of easing, arguably, more than any time in history. In support of the case for sluggish domestic economic growth, watch Avondale Chief Market Strategist (and transportation expert) Donald Broughton's comments on "Squawk Box" on Tuesday.
Below are my core objections to/concerns about Jim's view that higher interest rates will produce rising stock market valuations. The U.S. currently carries a record debt load. The U.S. is burdened with more debt than at any time in history. Our debt load now totals a record $17 trillion -- it topped $1 trillion in 1982, stood at only $5 trillion in 2000, was less than $8 trillion in 2005, and 2012 represented the first year since 1946 when the debt eclipsed GDP. The average maturity of the U.S. debt is a bit over five years. So, every 100-basis-point increase will result in an additional $170 billion of interest expense for the U.S. government. Rising interest rates, therefore, will result in a massive headwind to domestic growth - a potentially value destructive event for the market's valuations. Higher interest rates will jeopardize the U.S. housing recovery. It is generally agreed upon that in addition to buoying the U.S. stock market, quantitative easing is aimed to insure a steady and durable recovery in the residential real estate market, both with regard to new purchases and refinancing -- the latter is an important component to personal spending. While the U.S. housing market has recovered from the depression of 2007-2010, that recovery remains fragile. Home prices are up 8% year over year but still well below the prior peak of 2006. Any meaningful increase in interest rates will jeopardize housing and, in turn, slow any improvement in the domestic economy, another potentially value-destructive event. Higher interest rates will hurt other rate-sensitive areas of the economy. Installment lending, automobile lending and the like will feel the sting of higher interest rates. I worry that U.S. consumers and businesses have grown addicted to low interest rates and that any change of this status will cause an economic shock. Small businesses (and lesser corporate credits) will suffer disproportionately from rising interest rates. Small businesses, which have not had ready access to the capital markets to the degree that our largest companies have had, will be hurt by the rising financing costs associated with rising interest rates. In all likelihood, their already depressed confidence levels will get even more depressed. This could be another blow to growth and to market valuations. New structural headwinds exist today that never existed in previous times in history. While it may be argued that global easing has reduced the chance of economic tail risks, some serious issues remain (e.g., deleveraging, structural disequilibrium in the labor market, etc.) that are growth-deflating. So I would question Jim's examples of P/E multiples in previous rising interest rate backdrops, as those structural headwinds and challenges did not exist in the past.
Higher interest rates will provide a challenge to a further advance in equity prices. First, nearly every valuation model for the stock market is importantly influenced by the level of interest rates. A meaningful change (upward) in rates reduces the theoretical value of stocks and lowers the risk premium -- the latter being an oft-cited foundation for the bullish case. Second, given the screwflation of the middle class (stagnating incomes and rising costs of the necessities of life), individual investors could move even further away from stocks in favor of the safety of fixed-income investments (especially if rates and bond yields rise). Pension plans, too, may be less likely to invest in stocks if interest rates are rising toward their actuarial assumptions/needs. Moreover, demographics (the aging U.S. population) suggest that post-baby boomers and retirees will grow ever more conservative and could be attracted to the rising risk-free rate of return provided by higher interest rates. In summary, should the Fed exit quantitative easing earlier than expected thereby producing higher interest rates and a return to natural price discovery in the fixed-income markets (higher yields, lower prices), we have numerous structural, economic and profit risks today that did not exist in prior periods in history. As well, I am fearful that our economy (consumers and businesses) has become addicted to low interest rates and that the act of going off the drug on low rates will be far more painful than is commonly expected. As a result, it is my view that if Jim's forecast (of rising interest rates) proves correct, stock market valuations' will not expand. In fact, valuations might contract in the face of rising interest rates and the improving alternative of higher yields available in the fixed-income markets. I look forward to Jim's response to my view expressed in this morning's opening missive and a continued constructive debate between us.