The stock market has staged a partial rebound from its recent pullback, but Jim Paulsen, chief investment officer (CIO) at The Leuthold Group, sees "overheat pressure" building in the economy that, in turn, poses a severe risk for stock prices. In a recent client note, as quoted by Business Insider, he warned: "A common view that inflation and yields remain quite low and do not represent much of a threat for the stock market is simply incorrect. Because both wage and price inflation recently reached new recovery highs, overheat pressure seems poised to become even more pronounced."

Meanwhile, in a recent report entitled "No Margin For Error," Morgan Stanley indicates that a number of macro forces are exerting downward pressure on corporate profit margins, and this ultimately means downward pressure on stock prices. Among those forces are the two big threats that Paulsen sees, inflation that raises business costs in general and wage growth in particular. The list below indicates which industry groups Morgan believes face the highest risk of severe margin compression versus consensus estimates, according to the "Margin Heat Map" in their report. (For more, see also: This Stock Correction Is Now the Highest in a Decade.)

Heat Map: 6 Industries Have Highest Margin Risk

  • Materials
  • Transportation
  • Autos & Components
  • Consumer Durables & Apparel
  • Tech Hardware & Equipment
  • Semiconductors & Semiconductor Equipment

Source: Morgan Stanley

Significance for Investors

Paulsen added: "Concerns about inflation are perhaps rising more quickly than recognized. Wall Street's overheat mindset appears to be on the cusp of greater anxiety." He asserted that an "overheat round" in 2015 and 2016 was marked by accelerating wage and core consumer price inflation, and weighed on stock prices. Based on closing prices, the S&P 500 Index (SPX) slid by 2.1% from May 18, 2015 through Nov. 4, 2016.

"A common view that inflation and yields remain quite low and do not represent much of a threat for the stock market is simply incorrect." —Jim Paulsen

Source: Business Insider

Moreover, Business Insider observes, both stock and bond prices plunged in tandem during the recent pullback, as a spike in bond yields sent the prices of bonds tumbling, while also spurring selling by worried equity investors. In fact, contrary to popular wisdom, the prices of stocks and bonds have tended to be positively correlated during the last 20 years, the same article notes. On the few occasions in which their prices moved in opposite directions during those two decades, they have been marked by widespread selling of stocks. Paulsen calls this "a toggle switch which has historically magnified the negative impact of overheat pressure." (For more, see also: Why The 1929 Stock Market Crash Could Happen in 2018.)

Inflation in the U.S., as measured by the Consumer Price Index (CPI), was at annualized rate of 2.3% in September, down from a recent high of 2.9% in June and July, but up from roughly 0% through much of 2015, per data from the U.S. Bureau of Labor Statistics, as presented by Trading Economics. Wages and salaries grew at an annualized rate of 4.8% in August, the latest month for which data is available, roughly double the average rate of increase in 2015, per data from the U.S. Bureau of Economic Analysis, as presented by Trading Economics.

Looking Ahead

Morgan Stanley's "Margin Heat Map" indicates that several more industries than those listed above may be on the cusp of having a high risk of margin compression. Capital goods and retailing are vulnerable to peaking demand. Household & personal products, food & staples retailing, and food, beverage & tobacco all have made frequent mentions of cost pressures in their earnings releases and guidance. Energy, telecommunication services, and software & services all have consensus estimates that Morgan Stanley believes are excessively optimistic. Morgan Stanley also expects higher volatility, which may increase unease among investors, and set the stage for the anxiety-induced plunge that Paulsen foresees.

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