In a nutshell, Paulsen argues that if oil prices have bottomed and the current rebound to around $40 per barrel (or higher) is sustained, it may have significant repercussions on a wide range of financial markets. Because the U.S. dollar has been inversely correlated with oil prices for the past 15 years, higher oil prices imply a weaker dollar (or at least minimal further appreciation). This would represent a major change from the strong-dollar trend of the past two years.
In addition, Paulsen hypothesizes that with the U.S. economy near full employment, wages and inflation are likely to continue to rise (barring a recession), thereby pressuring corporate profit margins, earnings growth, and U.S. stock valuations. (We’ve been highlighting this risk to U.S. earnings growth expectations for a while now too.) This should also lead to higher inflation expectations and higher U.S. interest rates. Rising rates would not be good news for core bond prices, but would likely be positive for our non-core fixed-income funds.
This reflation scenario also suggests many of the most popular investment themes of the post-financial-crisis U.S. bull market—such as defensive and growth stocks outperforming cyclical value stocks, and U.S. stocks beating foreign stocks—could be reversed during the balance of this recovery.
To be clear, this isn’t a prediction of what will happen over the near term, but we think it is one plausible scenario among many that could play out. And while we use a short-term (12-month) time frame to run “reasonable worst case” stress-test scenarios as we manage our portfolios against various downside risks, it is nice to sometimes look at a “reasonable best case” and acknowledge the shorter-term “upside risks” to our portfolios as well.
Concluding Comments
Markets are cyclical, and for the past several years our portfolios have been facing some cyclical performance headwinds given our tactical asset class positioning and, more broadly, our long-term, active, valuation-driven investment approach. As discussed above, the sharp reversal in the markets beginning in the middle of the first quarter may indicate the market pendulum is starting to swing in our favor.
Even if the recent positive market trends turn out to be short term or reverse course, we remain confident that our disciplined investment process and risk-management process, consistently executed over time, will pay off over the completion of this full cycle, and through future cycles as well.
Jeremy DeGroot is chief investment officer at Litman Gregory Asset Management.