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“Bringing you national and global economic trends for over 25 yeEconomic and Market

Anxieties surrounding this recovery seem primarily tied either to the high labor unemployment

rate (which says more about the depth of the recession than it does about the character of the

current recovery) or to unrealistic expectations of what constitutes an acceptable economic

recovery growth rate. Many postulate the character of this recovery should be similar to earlier

post-war times when recovery real GDP growth rates often reached 5 to 8 percent. However,

since the mid-1980s, growth in the U.S. labor force has slowed noticeably. This secular decline

in the labor supply has permanently lowered the “speed limit” for U.S. recoveries making

comparisons to earlier recoveries unrealistic.

Despite a widespread belief the contemporary recovery is remarkably disappointing, its character

is quite similar to the last two recoveries (i.e., since the mid-1980s those which occurred since

labor force growth has downshifted). Unlike earlier postwar recoveries, and similar to today, both

the 1991 and 2001 expansions were sluggish at the start, were initially very slow in creating jobs,and neither initially boosted confidence much from recessionary levels. However, as we believe

will again prove to be the case with the current recovery, both the 1991 and 2001 recoveries did

eventually gear and ultimately produced decent economic and financial market results.

The Recovery is OK!?!Since the mid-1980s, the speed limit of the U.S. economy has been noticeably reduced by a

watershed downshift in the growth of the U.S. labor force. Prior to the mid-1980s, growth in the

U.S. labor supply was boosted by the baby boom maturation and by women entering the labor

market. The positive impact of these trends has waned in the last 25 years, forever lowering the

inherent speed of achievable economic growth. In the quarter century leading up to the mid-

1980s, annual real GDP growth exceeded 4 percent more than one-half the time, whereas since,

it has surpassed a 4 percent annual growth rate only slightly more than one-quarter of the time.

Moreover, prior to 1985, the annual year-on-year rate of real GDP growth often reached levelsbetween 5 to 8 percent. Since 1985, however, annual year-on-year growth has exceeded 5 percent

in only two out of 102 quarters!

For more than a quarter century, the U.S. economy has no longer been able (because of slower

secular labor force growth) to grow at rates that were commonplace during economic recoveries

of the 1960s and 1970s. Consequently, for U.S. leaders, policy officials, and investors to focus

on these periods as reference points in judging the contemporary recovery is improper. Such

comparisons will continue to lead to inappropriate economic and investment judgments. For

example, it has already fostered a belief the recovery is not sustainable, that economic policies

have not worked, and that more policy accommodation is required. We do not agree! When

compared to the character of the last two recoveries, the current recovery appears very “normal.”

In its first year, the contemporary recovery has produced faster real GDP growth (3 percent), has

more quickly returned to positive job creation, has produced more private payroll jobs, has beencharacterized by a much stronger profits recovery, and finally, has experienced a much more

robust stock market recovery than either the 1991 or 2001 recoveries.

Considering that the maximal growth rate in the U.S. economy is no longer much above 4 percent

real GDP growth, perhaps a 3 percent first-year growth rate is not as bad as widely perceived?

In short, by recognizing the lowered speed limit imposed on the U.S. economy in the last quarter

century, the current recovery appears okay! For this reason, policy officials may want to consider

that perhaps the current recovery is less a “new-normal” to be panicked over (with ostensibly

never-ending monetary and fiscal stimulus) than simply just “normal” (for the last 25 years)

which, like the last two recoveries, requires patience.

In This Issue:

Recovery Is NORMAL!!?

Household Burdens Only

Average!?!

Soft Patch Is Ending!!?

Components Of

Confidence??!

Three Major Confidence

Cycles Since 1970!?!

U.S. Is Making Progress

Against EmergingCurrencies!!?

The Inflation Cycle Is

Bottoming!!?!

Stocks And Jobs Joined

At The Hip???!

November 201

010-Issue 6 “Bringing you national and global economic trends for more than 25 yea“Bringing you national and global economic trends for more than 25 yea

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conomic & Market Perspective

Three Forces For Growth in 2011!??We expect about 2 percent annualized real GDP growth in the

just completed third quarter and anticipate an acceleration in

fourth quarter real GDP growth to about 4 percent. Should

this occur, the annual growth rate in real GDP will continue

to persist at about the 3 percent growth rate it achieved in the

first year of this recovery. Our initial expectation for 2011 is

for real GDP growth of about 3.5 to 4 percent being boosted by

three main sources of growth—major policy stimulus appliedto the economy since summer, restored capabilities in both the

business and household sectors, and a slow but steady rise in

economic confidence.

Unrelated to Federal Reserve actions, the economy has been

subjected to major policy stimulus since spring. First, long-term

interest rates have collapsed. In April, the 10-year Treasury

yield was about 4 percent and has subsequently declined to

about 2.5 percent. Similarly, the 30-year national mortgage rate

has fallen from almost 5.5 percent to about 4 percent. Second,

energy burdens have lessened. Crude oil prices were above $90

in April but subsequently have declined by about $10. Third,

from its summer highs, the U.S. dollar has declined by about 14percent. Finally, most bond yield spreads (mortgages, corporates

and municipals) have tightened again in the last few months as

European sovereign debt fears have calmed. This significant

package of policy accommodation (a major decline in long-

term rates, lower energy costs, an easing dollar and tighter yield

spreads) should boost economic growth in future quarters.

Due to the severity of the recession, most businesses and

households have thus far been focused on restoring their

fundamental capabilities. Today, a year into this recovery,

although additional fundamental improvements are still

necessary, businesses and households are in much better shape

to drive future economic growth.

Corporate profits have already fully recovered from the

recession, company cash flow generation has been spectacular,

the cash flow to capital spending ratio resides at a postwar high,

and corporate balance sheet ratios are stronger than at any time

in decades. Most corporate operations remain extremely lean.

Inventories, payrolls, and capital spending have thus far been

minimized while productivity growth has been maximized.

This cannot continue. Productivity seems to be slowing and

eventually businesses will be forced to expand operations

simply to meet demands. If accumulated profits and current idle

cash flows begin to be employed next year, the pace of businessinvestment spending, inventory build, and job creation could be

significantly enhanced.

Household fundamentals have also improved in the last year.

The debt burden facing the household sector (i.e., regular

financial obligations as a percent of disposable personal income)

was at an all-time record high in the first quarter of 2008, but

has since improved to only about average since 1980. Similarly,

the household energy burden is now below average compared to

the last 30 years! Household liquid asset holdings have surged

in the last couple years and currently reside at more than $7.5

trillion! After being virtually zero a few years ago, the personal

savings rate has risen to a 20-year high above 6 percent.

Following the job loss hemorrhage during 2009, the economy

has added about 96,000 private jobs a month so far this year,

contributing to about a 2 percent annualized real income gain

for the year. Home prices have experienced a mild advance for

more than a year, which when combined with the rally in both

stock and bond prices has produced a consistent recovery in

household net worth! To be sure, there are still many households

that have considerable problems yet to work through, but in

the aggregate, U.S. households enter 2011 with significantly

improved capability to again drive economic growth.

Perhaps the most valuable asset for future economic growth is

a slow but steady rise in economic confidence. Traditionally,

during economic recoveries prior to 1985, economic

confidence recovered quickly and robustly early in recovery.

Indeed, this could be one reason why first-year growth rates

in real GDP used to be much stronger compared to what

they have proved during the last 25 years. In this recovery,

like the last two recoveries, despite more than a full year of

economic revival, consumer confidence hovers at “bottomof recession” like readings. Consequently, like the last two

recoveries, the contemporary recovery will likely prove more

back-end loaded as a steady rise in confidence eventually

allows the impact of improvements in household and business

fundamentals to be realized.

2011 ... Sustained Recovery ReplacesDouble-Dip???!So far, there have been persistent doubts about the sustainability

of this recovery and everlasting fear that the 2008 crisis has

not yet truly ended. While 2011 might not bring a complete

return to economic normality, it will likely produce a broader

acceptance that a sustainable recovery has indeed beenaccomplished. Such a mindset would greatly assist the economy.

Government leaders and policy officials would stop spreading

panic by chronically having emergency meetings to discuss

what additional policy stimulus should be applied to the

economy. More importantly, should a consensus consider

the recovery sustainable, businesses could start to stretch

investment and planning horizons leading to an increase in

both capital spending and payrolls. We expect average private

monthly job creation to jump from slightly less than 100,000

this year to more than 200,000 next year. Stronger job creation

and faster income generation would improve consumer

confidence, boost retail sales, and promote a self-sustainingcycle of confidence enhancement. Moreover, with stronger job

and income trends, lowered debt burdens, and higher savings

rates, both the demand for and supply of household loans will

likely reemerge. In addition, with affordability at an all-time

high and with the return of jobs and credit worthiness, housing

activity should begin a slow recovery. Finally, businesses will

also likely increase inventory financing. Combined, these

trends should create a sense that the epicenter of the Great 2008

Crisis, the U.S. financial industry, is finally returning to normal.

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Novembe

The acceptance of a sustained economic recovery would also be

noticed in the financial markets. Without double-dip fears, would

the stock market be selling at only 14 times earnings with a 10-

year Treasury bond yield of only 2.5 percent, a core consumer

price inflation rate below 1 percent, and while profits continue

to rise? This valuation metric, at least in part, reflects a cultural

mindset that is still discounting a real chance of a double-dip

recession and/or the return of more serious “crisis” issues.

Finally, accepting a “sustained” recovery, even one that is modest,

would also radically alter the interest rate and economic policy

environments. A 3 percent growing economy does not support

a 2.5 percent Treasury yield unless most believe the recovery

is only temporary. Consequently, a broadening acceptance of a

sustained recovery may result in a quick return of the 10-year

bond yield toward 3.5 to 4 percent next year. It also would put

deflation fears on the back shelf and rapidly elevate inflationary

potential as enemy number one. Lastly, a consensus perception of

economic sustainability would bring intense focus once again on

the Fed’s exit strategy and force the first policy reversal (i.e., Fed

funds interest rate hikes) since the crisis began.

Investment Outlook??!!The stock market currently is very close to establishing another

new high for this recovery cycle. We are struck by how different

and by how much more favorable the backdrop surrounding the

equity market is today compared to when the S&P 500 first broke

above 1,200 in April. Three main factors—sentiment, valuation,

and policy push—make it much more likely the stock market

will soon push to new cycle highs where it failed last April.

First, last April when the S&P 500 rose above 1,200, optimism

was pronounced. Economic growth had proved stronger than

anticipated for several months, many were beginning to suspect

the economic recovery was about to experience several quartersof robust growth, and the discussion at the time was centered on

the Fed’s exit strategy. Today, by contrast, pessimism is much

more noticeable. The economy has been in a soft patch since

summer, many are worried the economy may be slipping back

into recession, and the Fed is discussing whether more “QE2”

is needed to ensure a sustainable recovery. While optimism may

have been too prevalent in April, today the stock market appears

to be climbing a wall of worry.

Second, the valuation of the stock market is much more

encouraging today compared to what it was last April. In the

spring, the S&P 500 trailing price-earnings (PE) multiple was

17.7 and its PE multiple based on one-year forward earningsestimates was 15.5. By contrast, today the trailing PE multiple

is currently 15.2 and the PE based on future earnings estimates

is 14. The stock market is also much cheaper on a relative basis

compared to the bond market. In April, the 10-year Treasury

yield surged to 4 percent, whereas in recent months, the 10-

year yield has plummeted below 2.5 percent! During the trading

range the stock market has been in since April, earnings have

continued to climb while bond yields have fallen, refreshing

stock market valuations!

Finally, most economic policies were working against the stock

market last April. Long-term Treasury and mortgage yields

had risen, oil prices soared to $90 in early April, the U.S.

dollar rose by more than 15 percent from its lows of 2009,

and most bond yield spreads were widening as Euro sovereign

debt fears escalated. In retrospect, these contractionary

policy forces slowed the economy in the second quarter and

consequently aborted the stock market rally in April. Today,

policy conditions surrounding the stock market are supportive.

Not only is the Fed considering additional quantitative easing

moves, but long-term Treasury and mortgage yields have

collapsed, oil prices have declined by about $10 from recent

highs, the U.S. dollar has retraced its entire advance of earlier

this year, and most bond yield spreads have tightened again as

Euro fears subside.

We believe conditions are good for the stock market to achieve

new recovery highs in the next several months. Investors are

climbing a wall of worry, valuations are cheap, and economic

policies are acting as a breeze behind the equity boat!

Stay With Cyclicals!!?Several suggest portfolios should emphasize larger-cap,

economically defensive sectors owing to the sluggish character

of this recovery. We continue to recommend overweighted

exposures toward economically sensitive areas including

emerging markets, small cap stocks, and the materials,

industrials, technology, and consumer discretionary sectors.

We remain inclined toward cyclicality for three main reasons.

First, this is the second global recovery led by emerging

economies. In the last recovery, under the leadership of the

emerging world, the stock market was dominated almost

throughout the recovery by cyclical exposures. Why?

Compared to developed economies, emerging economies tendto be comprised more by smaller companies who are involved

in industrial, raw materials and other more economically

sensitive pursuits. The character comprised by the new global

leadership may again dominate stock market performance as it

did in the last recovery.

Second, we think it is probably premature to move away from

cyclical exposures until policy officials have been in a full

fledged tightening mode for a period. Within the U.S., policies

remain unilaterally stimulative which typically encourages

economically sensitive leadership.

Finally, economically sensitive stocks will probably not befully priced until there is a broad consensus acceptance that a

“sustainable” economic recovery is underway. While doubts

about potential double-dip recession still linger, most cyclical

stocks probably remain undervalued.

James W. Paulsen, Ph.D.

Chief Investment Strategist, Wells Capital Management

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A “NORMAL” Recovery?!!?The average growth rate of the U.S. economy has slowed in

the last 25 years because of a secular downshift in the U.S.

labor force growth rate. Since the mid-1980s, real GDP growth

has seldom been above 4 percent, whereas before the mid-

1980s annual real GDP growth was in excess of 4 percent

more than one-half the time. Within the context of this new

slower growth U.S. economy of the last quarter-century, the

contemporary recovery appears very “normal.” These charts

compare various metrics of the current expansion to the last

two expansions during the last 25 years (i.e., the 1991 and

2001 recoveries). The cur rent recovery is 15 months old, and

although most consider this expansion pitifully disappointing,

as these charts illustrate, it is thus far stronger, or at least

on par, with the last two recoveries in terms of private non-

farm payroll gains, total private hours worked, real income

generation, and real consumption spending. Moreover,

compared to these previous two recoveries, the contemporary

recovery has also thus far (not shown below) outpaced in terms

of real GDP growth, corporate profit revival and stock market

recovery. While this recovery is disappointing compared to

older postwar expansions, in the newfound sluggish labor

force U.S. economy of the last quarter century, it appears to be

unfolding very “normally.” The last two recoveries were slow

to start and did not initially create many jobs, but eventually

both produced decent expansions. Perhaps U.S. leaders and

policy officials should show some patience rather than panic?!?

Economic Recovery Comparison

Non-Farm Private Payroll Employment*

1991, 2001, and 2009 Recoveries

*Non-Farm Private Payroll Employment is indexed at

1.0 at the beginning of each of the three recoveries

N o n - F a r m

P r i v a t e P a y r o l l E m p l o y m e n t a s a

r a t i o

o f i t s l e v e l a t t h e b e g i n n i n g o f t h e r e c o v e

r y


Total Private Aggregate Hours Worked*



Real Personal Income Proxy*



Real Personal Consumption Expenditures*


T o t a l P r i v a t e A g g r e g a t e W e e k l y H o u r s W o r k e

d a s a

r a t i o o f i t s l e v e l a t t h e b e g i n n i n g o f t h e r e c o v e r y

R e a l I n c o m e P r o x y a s a r a t i o o f

i t s l e v e l a t

t h e b e g i n n i n g o f t h e r e c o

v e r y

R e a l C o n s u m p t i o n a s a r a t i o o f

i t s l e v e l

a t t h e b e g i n n i n g o f t h e r e c o

v e r y

Number of months since start of recovery Number of months since start of recovery

Number of months since start of recovery Number of months since start of recovery

*Total Private Aggregate Hours Worked is indexed at

1.0 at the beginning of each of the three recoveries

*Aggregate Private Hours Worked times Average HourlyEarnings deflated by Personal Consumption Deflator Index

*Real Personal Consumption is indexed at 1.0 atthe beginning of each of the three recoveries

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Another similarity to the last two expansions (and strikingly

different from those recoveries that preceded the mid-

1980s) is a delayed recovery in consumer confidence.

During the 1970s and early-1980s recoveries, consumer

confidence typically surged higher as soon as the recession

ended. However, as this chart shows, similar to the last two

recoveries, despite more than a year of economic recovery,consumer confidence has yet to improve much in the

contemporary recovery. Does this mean economic policies

are not working? Does it imply the recovery is failing? That

a double-dip recession is nearing? Probably not. More likely,

a sluggish revival in confidence is yet another common

characteristic of recoveries in the new slower “labor force”

growth economy of the last 25 years. As during both the

1990s and 2000s recoveries, consumer confidence will likely

eventually improve and ultimately promote a decent economicrecovery. Patience, not policy, may be required!?!

Confidence Slow To Improve???

Consumer Confidence Index* and Recoveries*The Conference Board’s Consumer Confidence Index. Shown on

a natural log scale. Shaded areas represent recessions.

U.S. Household DEBT Burden**U.S. Household Financial Obligations Ratio (principal and interest

payments, lease payments, rental payments, homeowners’ insurancepayments, and property tax payments as a percent of disposable

personal income). Source: Federal Reserve Board

U.S. Household ENERGY Obligations Ratio****Personal Consumption Expenditures on Energy Goods and Services

(Table 2.3.5 NIPA Accounts) as a Percent of Disposable Personal Income.

Household “BURDENS” Now Only Average!!!?Household capabilities have improved much faster and by more

than widely perceived. Households were facing record high debt

burdens with record low savings. However, as this chart shows,

the household debt burden has already been improved to only

about average since 1980, the U.S. savings rate (not shown)

has recently risen to a 20-year high, and the household energy

burden is now below average. Moreover, home prices have

stabilized in the last year while both stock and bond prices have

rallied, causing a steady revival in household net worth. Finally,

after disastrous job losses during 2009, private non-farm job

gains have averaged just shy of 100,000 a month in 2010. These

have combined to produce about 2 percent real income and

consumption spending gains in the last year. No doubt, many

households are still struggling with debt burdens and lack of job

prospects. However, progress has been made and the aggregate

consumer may be in far better shape than widely perceived??!

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6 |

Most indicators suggest the economy is emerging from its

summer soft patch. The ECRI Weekly leading economic

indicator has been rising in the last month by the most since

it began declining last spring. The “boom-bust” leading

indicator recently reached a new recovery high, both the ISM

manufacturing and services sector surveys remain above the 50

percent expansion level (the ISM services survey actually rose

last month), business capital goods orders recovered in the latest

month, retail sales reports have recently surpassed expectations,

and the Philadelphia Fed’s state coincident economic indicators

now show only 5 states which have contracted this year! The

economy is probably beginning to benefit from easing forces

in place since early summer. Although the Federal Reserve

has not eased, the economy has been subjected to a set of

accommodative policies from the financial markets (i.e., the

Laissez-faire policy official). Long-term Treasury yields and

mortgage rates have collapsed since early May. Crude oil

prices reached $90 in early May and have since declined. The

trade-weighted U.S. dollar index has retraced its restrictive

(tightening) advance during the first half of this year. Most bond

yield spreads widened considerably earlier this year as European

sovereign debt fears escalated, tightening credit conditions for

municipalities, businesses and homeowners. However, since

the summer, most yield spreads have again tightened as Euro

fears have subsided. Fourth quarter real GDP growth is likely to

surpass expectations as it is boosted by financial market policy

easing (i.e., much lower long-term yields, lower energy cost, a

weaker U.S. dollar, and improving yield spreads).

“Soft Patch” Is Ending!?!

ECRI Weekly Leading Index of U.S.

Economic Growth

Boom-Bust Leading Indicator**Rolling 4-week moving average of CRB Raw Industrial Com-modity Price Index divided by Initial Weekly Unemployment

Insurance Claims.

ISM Manufacturing and Services Survey IndexesISM Manufacturing Survey Index (Solid Line)

ISM Services Survey Index (Dotted Line)

Levels above 50% Imply Expansion

Philadelphia Fed State Coincident Economic Indicators

Year-to-Date Annualized Growth Rates—By State

U.S. Capital GoodsNonDefense, Ex-Air New Orders

Billions U.S. Dollars

ICSC U.S. Retail Chain Store Sales Index4-week moving average of

Annual Growth Rates

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Post-Crisis Pessimism!??!The “Armageddon Hypochondriac” mindset remains

strong. A small temporary decline in retail sales earlier this

year caused widespread intense worries the economy was

headed for a double-dip recession. As this chart illustrates,

temporary monthly declines in retail sales are not at all

uncommon during ongoing recoveries. Mild monthly

declines in retail sales during 2004 or 2006 were largely

ignored. However, in the “crisis-heightened” cultural mindset

of the day, a similar decline leads to a recession panic. Don’t

get derailed by “bad news” that is overemphasized. Rather

than signaling the end of the recovery, it more likely signifies

a post-crisis cultural psychosis?!?

U.S. Total Nominal Retail Sales

Billions of U.S. Dollars

Total Annualized U.S. Auto Sales Rate

Millions of Units

Auto Sales Have Died Before ... And Recovered!!!The level of auto sales is certainly depressed. However, the

U.S. auto market has been here before (at least in the early-

1980s and close in the early-1990s) and recovered. As in

earlier auto market collapses, the biggest asset that is likely to

promote auto sales in future years is a ballooning in pent-up

demands. The auto market has been down and out before and

eventually recovered. It probably will again!!?

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8 |

Perhaps the strongest force for future economic growth is

a slow but steady rise in economic confidence. Capabilities

in the corporate sector are quite strong and although many

households are in need of further fundamental improvements,

aggregate household finances have also improved significantly

in the last couple years. However, for “fundamental

improvements” in the household and corporate sectors

to positively impact the economic recovery, confidence

needs to rise. These charts illustrate three main drivers of

confidence—profits, jobs, and wealth—which are likely to

eventually lift economic spirits. Corporate profits is one of the

most important determinants of “consumer” confidence. Why?

Because profits are what ultimately create the things (e.g.,

jobs, incomes, higher stock prices, etc.) that are important to

households. As the chart shows, on a detrended basis, while

the revival in profits has helped improve confidence, profits

still need to grow further to lift confidence beyond recession-

like lows. We expect the job market to strengthen noticeably

in the coming year, which should help consumer confidence

measurably. Finally, household net worth has risen steadily

in the last couple years, which eventually should improve

household moods.

Components of Confidence??!

Consumer Confidence vs. Corporate Profits

Consumer Confidence vs. Job Market*

Consumer Confidence vs. Household Net Worth*

C o n f e r e n c e B o a r d ’ s C o n s u m e

r C o n f i d e n c e I n d e x

N a t u r a l l o g s c a l e

( S o l i d )

T o t a l U . S .

N I P A C o r p o r a t e P r o f i t s a s a

P e r c e n t A b o v e / B e l o w T

r e n d l i n e A v e r a g e

L e v e l S i n c e 1 9 6 5 ( S o l i d )

J o b l e s s C l a i m s a s a r a t i o o f U . S .

L a b o r F o r c e

I n v e r t e d S c a l e . ( D o t t e d )

C o n f e r e n c e B o a r d ’ s C o n s u m e r C o n f i d e n c e

I n d e x . N a t u r a l l o g s c

a l e .

( S o l i d )

C o n f e r e n c e B o a r d ’ s C o n s u m e r

C o n f i d e n c e I n d e x

( S o l i d )

*Weighted average of the 1, 4, 7, and 10 year average annualizedgrowth rates in inflation-adjusted Household Net Worth.

W e i g h t e d H o u s e h o l d A n n

u a l i z e d N e t

W o r t h G r o w t h * ( D o

t t e d )

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Three Major Confidence Cycles Since 1970?!?In the last 40 years, the U.S. has experienced three major

economic confidence cycles. The top chart overlays the actual

rate of annual real GDP growth (solid line) with the mean

estimated annual real GDP growth rate made by professional

forecasters one year earlier. Essentially, the solid line is the

economic reality and the dotted line represents its expectation

a year earlier. The lower chart is the difference between the

actual real GDP growth rate and what was expected a year

earlier. That is, this chart illustrates the consensus forecasting

error. In the 1970s until the beginning of the 1980s recovery,

actual real GDP growth typically was close to what was

anticipated. Not every year, but throughout this period there

was not a chronic and consistent forecasting error. That is,

some years produced stronger-than-expected growth and some

weaker-than-expected growth, so over time, the economy

did not persistently outpace nor underperform expectations.

Overall, reality typically synced with expectations.

Consequently, this era did not create excessive optimism or

excessive pessimism. However, beginning with the 1983

recovery and continuing until the 2000 dot-com top, the actual

economic growth rate perpetually outpaced expectations. That

is, the consensus view was chronically pleasantly surprised.

Ultimately, this led to the “new-era” mania which ended with

a ridiculous period of optimistic economic future forecasts

and remarkably rosy risk asset valuations. The last decade has

been just the opposite. Actual economic growth has chronically

been disappointingly slower than anticipated. Similar to what

led up to the new-era mania, more than a decade of economic

disappointments has culminated in a “new-normal” mania,

which we believe (in retrospect) may prove a ridiculous period

of pessimistic future forecasts and unbelievably cheap risk

asset valuations. Just food for thought???

Actual vs. Forecasted Annual Real GDP GrowthActual Annual Real GDP Growth (Solid)

Mean Estimated Annual Real GDP Growth derived one-year earlier from thePhiladelphia Federal Reserve Survey of Professional Forecasters

Economic Growth Consensus Forecasting Error*

*Year-ahead actual annual realGDP growth less forecasted real

GDP growth.

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Corporate Profits Are UP... Will Small Company Profits Follow???This chart overlays corporate profits with small company

profits (i.e., proprietors’ income). While corporate profits

have already fully recovered their recessionary decline, small

company profits have not yet enjoyed much recovery. Indeed,

small company profits peaked in the mid-2000s and have

suffered the most prolonged period of malaise since the early-

1980s. This is a concern. Not sure what it will take and how

long it will be before small companies also begin to reap

rewards from this recovery???

Corporate Profits vs. Proprietors’ IncomeTotal U.S. Corporate Profits with CCA & IVA adjustments, in Billions (Solid)Total Proprietors’ Income with CCA & IVA adjustments, in Billions (Dotted)

Shown on a natural log scale.

Emerging Market U.S. Dollar Currency Index**Weighted index of nine emerging economy currency ratesagainst the U.S. dollar including Brazil, Chile, Mexico, China,India, S. Korea, Taiwan, Poland, Israel, Turkey and S. Africa.

U.S. is Making Progress Against Emerging Currencies!!?Currency concerns have escalated. Of primary concern

are emerging countries pegging currency rates at woefully

low levels. This concern is particularly acute with China.

However, as this chart illustrates, the U.S. is making

progress against emerging world currencies. This currency

index is a geo-weighted index against 11 leading emerging

economies including China. It has declined 15 to 20 percent

from its highs during the height of the 2008 crisis and is

nearing the lows it reached in 2008. Emerging world trade

contributions to U.S. real GDP growth is important to the

U.S. recovery. The decline in this currency index bodes well

for emerging trade improvements during 2011!?

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Has Savings Rate PEAKED!!!?Many are worried the savings rate needs to rise substantially,

which would hold back consumer spending in this recovery.

However, as this chart shows, the personal savings rate

typically peaks during recessions and has never risen on a

sustained basis during expansions. In every expansion since

1950, the savings rate either hovered about its peak during the

last recession or it declined. The savings rate peaked at about

6 to 7 percent at the end of the recession last summer. We

do not think it will rise much beyond this level until the next

recession. Consequently, real personal consumption can grow

in line with real incomes as it has in past recoveries.

U.S. Personal Savings RateShaded areas represent recessions.

Annual Sales Growth for S&P 500 Index by Sector

Top-Line Growth Better Than You Think?!??The dramatic profit surge in this recovery is widely

considered the result of cost-cutting and margin

enhancements. Many are concerned about future earnings

growth since profit margins are already near historic highs

and most perceive sales trends as anemic. At least among

S&P 500 companies sales growth has proved fairly strong.

In the first quarter, annual sales growth was about 12 percent

and only slowed to about 9 percent in the second quarter. In

an economy with less than 1 percent core consumer price

inflation, about 2 percent wage inflation and with a 10-year

Treasury yield of only about 2.5 percent, 8 to 10 percent sales

growth seems pretty impressive!?!

Source: Bloomberg.

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Is Inflation Bottoming?!?!The inflation cycle is showing the classic signs of bottoming.

The lowest stage prices— i.e., CRB raw industrial prices—

bottomed in late 2008. Next stage core producer price

inflation bottomed in late 2009. Next stage core consumer

price inflation bottomed this summer and the cycle will be

confirmed by a last stage wage inflation bottom. We do believe

the inflation cycle is nearing a low for this cycle and deflation

will likely be avoided. However, we are still on the fence as

to whether this inflation bottom will be followed by a period

of generalized price stability (for example, characterized by

a range in core consumer price inflation between 1 and 3

percent) or whether it will eventually deteriorate into a more

serious and chronic inflationary problem. Inflation will not

likely be a problem for 2011 (although it will likely show a

clear bottom) but may become an issue beyond next year??!?

12 |

CRB Raw Industrial Commodity Price Index

Shown on a natural log scale.

Core Consumer Price Inflation Rate*

*Six-month annualized inflation rate, 3-month moving average.

Core Producer Price Inflation Rate*


Average Hourly Earnings (Wage) Inflation Rate*


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Emerging Market Global Cycle... Continues!!??The last recovery (2001 to 2007) possessed several unique

characteristics because it was the first led by emerging world

economies. The contemporary recovery is the second emerging

market led global cycle and several components central to

the last recovery are again evident. The lower chart shows

throughout the last decade emerging market stocks led the

global stock market. Recently, relative to the S&P 500 Index,

emerging market stock prices rose to a new all-time record

high, completely recovering its relative loss occurred during

the crisis. The U.S. dollar exchange rate was weak throughout

the last expansion and currently is again nearing the lows it

established in 2008. Finally, raw industrial commodity prices

(the essence of most emerging economies is industrial and

materials oriented) recently broke to new all-time highs!

The character of an emerging economy led global recovery

cycle of a weaker U.S. dollar, rising commodity prices and

outperforming emerging market stocks seems to be continuing

along its trends of the last decade??!

U.S. Trade-Weighted BROAD Dollar IndexShown on an INVERSE natural log scale.

CRB Raw Industrial Commodity Price indexShown on a natural log scale.

MSCI Emerging Market Relative Stock Price Performance**MSCI EM Index divided by S&P 500 Index. Shown on a natural log scale.

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14 |

A New Recovery Stock Market High?!?As the stock market again approaches its recovery high of

mid-April, we note how much more favorable the backdrop

is for the equity market today compared to when the S&P

500 first broke above 1,200. Three main factors—sentiment,

valuation, and policy push—make it much more likely the

stock market will soon push to new cycle highs where it failedlast April. First, when the S&P 500 first broke above 1,200

in April, optimism was pronounced. Economic growth had

proved stronger than anticipated and the national discussion

centered on the Fed’s exit strategy. Today, pessimism is much

more noticeable. The economy has been in a soft patch since

summer and the Fed is discussing whether more “QE2” is

needed to ensure a sustainable recovery. Second, when the

market reached its high in mid-April, the S&P 500 trailing

price-earnings (PE) multiple was 17.7 and its PE multiple

based on one-year forward earnings estimates was 15.5.

Today, by contrast, the market is much cheaper. The trailing

PE is currently 15.3 and the PE based on future estimates is

about 14. Moreover, while the market PE is much cheaper,

so is the competitive Treasury bond yield (today it is about

2.5 percent versus about 4 percent at the April high). Finally,

whereas economic policies were working against the stock market in April (e.g., long-term yields had just surged, oil

prices peaked at $90, and the U.S. dollar had risen almost 20

percent) they are supportive of the stock market now (e.g.,

Treasury and mortgage yields have collapsed, oil prices are

lower, and U.S. dollar weakness has been accommodative).

Conditions are good for a stock market surge to new recovery

highs in the next several months. Sentiment is climbing a wall

of worry, valuations are cheap, and economic policies are

acting as a breeze behind the equity boat!?!

S&P 500 Composite Stock Price Index

Cyclically Sensitive Stock Relative Price Performance**Morgan Stanley’s Cyclical Stock Price Index divided by S&P 500 Stock

Price Index. Shown on a natural log scale.

Small Cap Stock Relative Price Performance****Russell 2000 Stock Price Index divided by S&P 500 Stock price

Index. Shown on a natural log scale.

How to Survive the 2008 Crisis... Cyclicals and Small Caps!??The worst crisis since the Great Depression and one of the best

places to hide was in cyclical, small cap, and emerging market

stocks? Say what? Perhaps related to the reinstatement of the

“emerging global cycle,” both cyclical stocks and small cap

stocks have returned to their chronic leadership exhibited

during the last recovery. Many have long advocated moving

toward economically defensive and large cap stocks. These

charts (and trends) may give one pause.......??!

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In the last five years, the correlation between stock price

movements and monthly job creation has been stronger than

at any time in the postwar era! This illustrates the current

job obsession is shared both on Main Street and Wall Street.

Indeed, the only tonic at this point to calm widespread

economic fears is probably “jobs.” We expect job creation to

improve enough in the coming year to finally calm double-

dip fears and to gain a consensus acceptance in a sustainable

recovery. As this chart illustrates, this could create a

significant rally in the stock market?!?

Are Stocks and Jobs Joined at the Hip???

Jobs and Stock Market Correlation**Trailing 60-month correlation coefficient between monthly percent

changes in private nonfarm payroll employment and monthly percentchanges in the S&P 500 Composite Stock Price Index.

My... What a Difference a Decade Makes?!?This chart is a good illustration of just how much the “new-

era” mania of a decade ago has given way to a “new-normal”

mania today. The dotted line shows the distribution of excess

earnings yields (i.e., the earnings yield of each stock less the10-year Treasury yield) available at the peak of the stock market

on March 24, 2000 and the solid line shows the same valuation

distribution today. In 2000, even though cash was offering 6.5

percent yields, virtually nobody held cash. Rather, most were

loaded up on equities even though about one-half of S&P 500

stocks offered earnings yields below the 10-year Treasury yield.

Today, even though almost all S&P 500 stocks offer an earningsyield in excess of the 10-year Treasury yield most prefer to hold

cash (even though it offers no return) or bonds (even though

they offer only about 2.5 percent yields). Hmmmmm......???

Distribution of S&P 500 Stock Price Index

Forward Earnings Yield* Less 10-Year Treasury Bond YieldOctober 2010 vs. March 2000

*IBES mean estimated forward 12 months earnings as a percent of the current stock price.

E a r n i n g s Y i e l d l e s s B o n d

Y i e l d

Number of S&P 500 Companies

Distribution of excess Earnings Yields as of October 14, 2010

Distribution of excess Earnings Yields as of March 24, 2010

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Wells Capital Management (WellsCap) is a registered investment adviser and a wholly owned subsidiary of Wells Fargo Bank, N.A. WellsCap provides investment management services for a variety of institutions.The views expressed are those of the author at the time of writing and are subject to change. This material has been distributed for educational/informational purposes only, and should not be considered asinvestment advice or a recommendation for any particular security, strategy or investment product. The material is based upon information we consider reliable, but its accuracy and completeness cannot beguaranteed. Past performance is not a guarantee of future returns. As with any investment vehicle, there is a potential for profit as well as the possibility of loss. For additional information on Wells CapitalManagement and its advisory services, please view our web site at www.wellscap.com, or refer to our Form ADV Part II, which is available upon request by calling 415.396.8000.

WELLS CAPITAL MANAGEMENT® i i t d i k f W ll C it l M t I

Gold Or Just a Commodity ETF???Gold prices did very well during the peak of the crisis in late

2008 and early 2009. However, despite all the accolades, the

price of gold has not done any better than other commodity

prices since crisis fears peaked in March 2009! Gold probably

still has a “fear premium,” which presents a risk for investors

should sustained recovery expectations take hold. If you’re

worried about inflation, probably better to hold a diversified

commodity basket rather than simply gold. Anyway, something

to challenge your strategy?!?!

Price of Gold

2008 Housing Crisis Stocks vs. 2000 Tech Crisis StocksRelative stock price performance of the S&P 500 Homebuilders index.

This relative price is set to 1.0 on July 20, 2005 which was the peak relativeprice performance for the homebuilding sector stock index. (Solid)

Relative stock price performance of the S&P 500 Infotechnology sector index.This relative price is set to 1.0 on March 10, 2000 which was the peak relative

price performance for the technology sector stock index. (Dotted)

Housing Stocks?? Could be a Lonnng Wait!!?Housing stocks are probably very cheap today, but if

technology stocks are any guide (i.e., the epicenter of the last

crisis in 2000), housing stocks may remain cheap for some

time to come. This chart overlays the relative stock price

performance of housing stocks (solid line) with the relative

price performance of technology stocks during the dot-com

bust. Both indexes are set to 1.0 at their respective peaks

(housing stocks on July 20, 2005 and technology stocks on

March 10, 2000). The pattern of these two manias are very

similar—both leading up to and in the aftermath of the manias.

As technology stocks suggest, housing stocks are probably safe

to buy today. That is, they are likely done underperforming.

However, if they continue to follow the pattern of relative price

performance of technology stocks after the crash in 2000, then

it may be several years before housing stocks soundly outpace

overall market indexes!?!?

Relative Price of Gold to All Commodity Prices**Gold Price divided by CRB Commodity Price Index

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