A quick glance at a multi-year chart might give someone the impression that being a stock trader is easy. Pretty much everything has gone up, so how hard could it possibly be?
That mentality is vastly underselling how difficult conditions are for investors as they face a crucial crossroads for the future of the market.
On one hand, the economy is chugging along nicely and corporate profits are soaring. But on the other, the nine-year-old bull market is already one of the longest on record, and trepidation around the next big meltdown mounts with every passing day.
This understandably leaves investors mired in what one expert describes as a “constant conundrum,” leaving little room for error. Do they cut the cord and risk missing another leg of strength, or do they stay the course as the spectre of a corrective phase looms? The health of their portfolios depends on that decision.
That’s where the aforementioned expert, Jim Paulsen, comes in. As the chief investment officer of Leuthold Group, he empathizes with the plight of traders. But he also might hold the key to the future of the market.
An important relationship at the heart of stock sentiment
Before we reveal Paulsen’s secret weapon, it’s important to understand the relationship between two groups he uses as proxies for market health and investor sentiment — cyclical and defensive stocks.
Cyclical equities have historically outperformed during times of market strength and economic expansion, while defensives tend to take the reins during weak stretches, including the periods immediately preceding past recessions.
So the investment decision over whether to sell cyclicals in favor of their defensive counterparts largely depends on where investors think we are in the grand scheme of the market cycle.
As you can see in the chart below, cyclicals are outperforming defensives by the most since the dotcom bubble, indicating a high degree of investor confidence. But what comes next?
This is where Paulsen’s favorite indicator comes in.
An all-important market signal
At the epicenter of Paulsen’s market assessment is a single economic indicator: consumer confidence. And the thinking around it matches the idea outlined above — that a decline in the measure signals rough times ahead for the market, and a likely rotation into defensive stocks. And vice versa.
“Over most of the post-war era, the performance of cyclical stocks relative to defensive stocks has been closely associated with the level of consumer confidence,” Paulsen said in a recent client note. “Not only are cyclical and defensive stock returns impacted, but their investment risk/return frontiers also vary widely depending on the degree of confidence evident throughout the economy. This is a constant conundrum for portfolio managers.”
In order to test this historical relationship, Paulsen has divided consumer confidence into four quartiles, then calculated the relative performance of cyclicals versus defensives for each one.
With all of that established, the chart below tells you everything you need to know. Now allow us to unpack it.
As you can see, cyclicals handily outpace defensives when confidence is at its highest. That lines up with what we’ve established. What’s more surprising is the underperformance of cyclicals when confidence is in its third quartile. Theoretically, they should still be winning, just at a lesser degree than in a fourth-quartile environment.
With that in mind, what Paulsen’s findings ultimately show is that the market has historically started to falter not when confidence is peaking, but rather when it’s mired in the no-man’s-land of the third quartile. And while Paulsen is stumped as to the exact reason, the information he’s gleaned is more than enough to inform stock allocation decisions.
What now?
Now that Paulsen has given you a handy tool for checking market sentiment, you still have to know how to use it.
Let’s start with consumer confidence, of course, which Leuthold notes is currently in its highest quadrant relative to the post-war era. This implies the market is in a “euphoria stage” — a label that might make investors balk — but is actually a positive when you consider Paulsen’s methodology.
According to his data, since 1952, cyclical stocks have beaten defensive ones by almost 700 basis points per year when consumer confidence has been in its top quartile. In other words, traders would be foolish to give up now, with gains still out there for the taking.
Paulsen does acknowledge, however, that a euphoric atmosphere is usually a signal that a period of expansion is aging. So if investors are going to continue riding the wave higher, the least they can do is watch consumer confidence like hawks.
“Although stock market risks are evident today (e.g., valuations are extended, financial liquidity is contracting, interest rates are rising, and inflation pressures are intensifying), making it uncomfortable to invest in stocks sensitive to the economic cycle, investors should consider staying overweight cyclical stocks until the Consumer Confidence Index again moves below its highest quadrant,” he said.
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