Stocks are signaling that economic strength isn't as strong as people think, strategist says

• Jim Paulsen says signals in the stock market show economic strength is being overestimated.
• Consumer discretionary stocks are struggling, indicating a weaker US consumer.
• Cyclical stocks' price drop suggests economy nears recession, he added.

The labor market is strong and the economy appears to be holding up in the face of the Iran war, but under the hood of the stock market, more ominous signals are flashing, according to Jim Paulsen.

The Wall Street veteran and the former chief investment strategist of The Leuthold Group said while the jobs report signals a strong economy, the stock market is flashing a warning.

"Despite a small increase in employment, the relative price of employment services stocks has not shown any sign of improvement in overall job conditions," Paulsen wrote in a Substack post on Tuesday. "The relative stock price of this employment index remains near its lowest level in at least 26 years."

Paulsen highlighted the historic relationship between the performance of consumer discretionary stocks and real retail sales, noting that for decades, they have moved in the same general direction. S&P discretionary stocks have consistently underperformed the broader market, implying sluggish consumer spending.

Since these stocks began to fall in 2020, inflation-adjusted retail spending has seen only modest growth.

"Consumer discretionary stocks are showing no lift from the recent better than expected jobs numbers with their relative price currently near its lowest level since 2011," Paulsen noted. "Consumer stocks on Wall Street are suggesting retail results on Main Street are poised — not to improve soon on better job prospects — but rather to worsen further."

That's not the only negative economic cue that Paulsen is taking from Wall Street, though.

He also highlighted cyclical stocks, companies whose performance is most closely tied to the performance of the broader economy, as another group that has struggled recently.

This category and consumer discretionary stocks often overlap, as many of them belong to firms who provide nonessential products and services, such as automotive producers, travel and leisure services and luxury retail products. Paulsen maintains that investors should also be paying careful attention to the trend.

"Cyclical stocks — those most sensitive to the pace of economic growth — are suggesting the economy is closer to a recession than a period of improvement," he said. "The relative stock price of the S&P 500 cyclical sector has collapsed since early this year and is currently trading near its lowest relative price since 1990."

Paulsen also noted that these stocks are performing in a way that closely mirrors their action prior to or during previous recessions, citing 1990, 2002, 2009-10, and 2020 as examples.

"The speed of the collapse in the relative price of cyclical stocks and their current relative price low both portray a weak U.S. economy," he added.

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