A Wall Street expert lays out the exact scenario that could cause the stock market's next big meltdown

  • Jim Paulsen, chief investment strategist at Leuthold Group, thinks a metric once “left for dead” could put an end to the decade-plus bull market.
  • He points to the unemployment rate, accommodative global central bank policies, and an expected weakening of the US dollar to bolster his thesis.
  • Paulsen is not alone in his views either. Tony DeSpirito, the chief investment officer for fundamental US active equities at BlackRock, and Chris Brightman, the chief investment officer at Research Affiliates, have expressed similar concerns.
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After the S&P 500 posted a total return of 31% in 2019, investors are entering 2020 bright-eyed and bushy-tailed. In fact, in the last decade, stocks have only experienced one down year on a total return basis: negative 4.38% in 2018. Not exactly earth-shattering.

But just because the market has been on a tear since emerging from the Financial Crisis doesn’t mean money managers aren’t well aware of the risks afoot.

Jim Paulsen, chief investment strategist at Leuthold Group, thinks a metric that was once “left for dead” has the power to uproot the stampeding bull. He’s referring to inflation, for which he says a sharp increase would threaten the nearly 11-year rally.

“It is my belief that US inflation has only paused and will eventually rise enough to end this economic recovery and bull market,” Paulsen penned in a recent client note. “Consequently, the biggest financial risk, and perhaps the biggest potential surprise in 2020, could be an inflation rate that recovers much more quickly and aggressively than expected.”

Inflation impacts stock returns in a multitude of ways. But historically speaking, stocks tend to produce below-average returns in periods of high inflation.

Companies experience an increase in cost of goods sold while higher interest rates — induced by the Federal Reserve in order to combat inflation’s harmful effects — swell expenses. As a result, investors generally become less optimistic over a company’s ability to increase its profits enough to offset the expansion in costs. It doesn’t help that rate hikes also decrease the appeal of stocks versus bonds.

That combination doesn’t bode well for equities — and Paulsen isn’t alone in his worries.

Others have expressed concerns

Tony DeSpirito — the chief investment officer for fundamental US active equities at BlackRock — and Chris Brightman — the chief investment officer at Research Affiliates — recently sounded the alarm on this exceptionally low period of inflation, referring to the phenomenon as “the hidden risk longer term” and not “normal.” 

Although conventional measures of inflation depict stable pricing pressure within the economy, Paulsen notes that less popular measures indicate that a resurgence may be in order.

“The Cleveland Federal Reserve’s ‘Trimmed Consumer Price Index’ — a measure of consumer inflation that attempts to remove volatile items which may distort the true inflation picture — continued to rise during 2019 and is currently at its highest level since early 2012,” he said. “Similarly, the median consumer price inflation rate (a central tendency of inflation) recently rose to its highest level since 2008!”

In order for Paulsen’s bull market-ending prognostication to come true, stocks would need to take more than a 20% peak-to-trough dive — the threshold that defines a bear market.

That said, although Paulsen is clearly aware of the risks a surprise uptick in inflation would bestow on equities, he doesn’t think it will “meaningfully hurt the stock market or produce a recession in 2020.”

In short, investors are safe for the time being. 

“Every economic recovery in the post-war era has ended only after a period of overheat problems, and this recovery will likely end in a similar way,” he said.

He continued: “With the unemployment rate at 3.5%, investor inflation expectations rising since October, with full-on global policy easing, an expectation of a weak U.S. dollar this year (which could intensify inflation pressures), and a global recovery on the horizon, U.S. inflation—widely left for dead—could quickly emerge and become a primary focus.”

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