Episode #498: Liz Ann Sonders on The State of the Markets
Guest: Liz Ann Sonders is the Chief Investment Strategist of Charles Schwab. She has a range of investment strategy responsibilities, from market and economic analysis to investor education, all focused on the individual investor.
Recorded: 8/16/2023 | Run-Time: 57:07 
Summary: In today’s episode, Liz Ann starts off by sharing some timeless lessons from her mentor, the great Marty Zweig! Then she shares her view of the economy and markets. She touches on earnings estimates, expectations for the Fed, market breadth, and where she sees opportunity going forward.
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Links from the Episode:
- 1:08 – Welcome Liz Ann to the show
- 1:28 – How Marty Zweig’s sentiment indicators had a lasting impact on Liz Ann Sonders’ approach
- 5:26 – Marty Zweig’s Investing Rules
- 5:42 – Reminiscences of a Stock Operator
- 7:30 – Rukeyser’s advice to Liz Ann: Explain finance so non-finance parents understand
- 10:01 – Understanding rolling recessions: A pandemic-era phenomenon
- 12:54 – Unprecedented weakness in leading indicators (LEI) hints at potential recession
- 15:49 – Housing market varies between existing/new and single/multifamily homes
- 19:27 – Fed’s future path unclear
- 22:46 – Wide range in outcomes after rate hikes shows no typical market behavior
- 24:39 – Market’s unpredictability and rich multiples require earnings growth for justification
- 28:33 – Analysts are uncertain about future earnings
- 39:30 – Emphasizing international diversification, especially in Japan
- 42:30 – Investors are turning to treasuries for yield
- 47:11 – Why this year feels like a “wall of worry” market
- 48:11 – Why the “get in, get out” approach to investing is gambling, not disciplined strategy
- 51:03 – What investment belief Liz Ann holds that most of her professional peers do not
- Learn more about Liz Ann: Charles Schwab; Twitter;
Transcript:
Meb:
Welcome podcast listeners, we have a special episode today. Our guest is Liz Ann Sonders, the Chief Investment Strategist of Charles Schwab.
In today’s episode, Liz Ann starts off by sharing some timeless lessons from her mentor, the great Marty Zweig! Then she shares her view of the economy and markets. She touches on earnings estimates, expectations for the Fed, market breadth, and where she sees opportunity going forward.
Meb:
Liz Ann, welcome to show.
Liz Ann:
Thanks for having me. Nice to be here.
Meb:
I’m really, really excited to have you on the show today. I’ve been looking forward to this for a long time. We’re going to get into all sorts of stuff today, but I can’t start this without somewhat starting at the beginning because, this is for the younger listeners really, older crowd may know who Marty Zweig was but a massive influence on me early in my career reading everything he had written, really a titan of our industry and you had the chance to get started working with him. Can you just tell the listeners real quick who Marty Zweig was?
Liz Ann:
Yeah. And you’re right, Meb. He was just an icon.
And it was funny because when I graduated undergrad I didn’t know what I wanted to do other than I wanted to live and work in New York City. So I actually had a bunch of initial interviews across the spectrum of industries. It wasn’t all finance companies and had this interview set up with Zweig, Avatar and of course, I wanted to do some research on the company and Marty and his partner Ned Babbitt, and at that time no internet, no social media, so I literally was in the library turning the crank on the microfiche and reading newspaper articles. So that was my first introduction to who he was.
And quite famous at that point, had the bestselling investment newsletter ever at that time, publicly traded mutual funds, started one of the first ever hedge funds which was still going, Zweig-DiMenna Partners. Coined the phrase, “Don’t fight the fed.” There’s the Zweig breadth thrust indicator. He invented the put/call ratio. Famously, in 1987, he was on Wall Street Week with another late great, Lou Rukeyser, and precisely predicted the crash of ’87 three days before.
And what was interesting about that time is I had only been at the company a year at that point. So I started in September of 1986 and by August of 1987, we were asset allocators. I was on the institutional side of the business. Marty ran again the hedge funds and the mutual funds and on the institutional side, we’d gone from close to fully invested in equities down to only about 20% invested in equities by the end of August and in Marty’s case in the hedge fund in particular, basically went net short. Fast forward to October 19th, the market crashes and we start buying aggressively.
So naïve 22-year-old me thinks, “Why is everybody freaking out? You just figure out beforehand that a crash is coming, take all your money out, the crash happens and you go in at lower prices.” Little did I know how hard that was.
Meb:
It reminds me when we started Cambria, this is right before the global financial crisis and we had written a trend falling paper, very basic stuff, and trend falling did great during the GFC, but it was very similar… I remember skipping into work because we were sitting in cash but everyone I was working with was just pale. Every day, the market… Lehman closing, market… I was like, “What are you guys upset about? The trend falling seems to be working. This seems so simple,” and of course, it’s never so simple.
Liz Ann:
It’s never simple.
Meb:
I had a blog post. I just looked it up. Ten years ago, it was about Marty Zweig because we’ve had Jim Rogers on the show and I love him but he had a quote where he said, “I’ve never met a rich technician,” and technician like technical analysis used to be a phrase that I feel like was derogatory by the vast majority of the investment industry. Today, it’s been glossed over and if you call people quants then it’s a much more sophisticated people are on board. If you look at the top 10 hedge fund managers every year, it’s like most are technician quanti. They may not call themselves technicians but quanti.
So I had this post where he says, “I’ve never met a rich technician,” and then a giant says Marty Zweig penthouse could fetch 120 million. It was the most expensive piece of New York real estate was from a “technician.”
Liz Ann:
I was in that apartment. It was quite spectacular.
Meb:
So I’m not going to ask you to recite all of his rules because there’s many, and we’ll put it in the show note, listeners, but they’re pretty fantastic. But is there one that sticks out in your mind? You mentioned don’t fight the fed. Is that the one that really sits home for you or is there another one where you’re like, “You know what?”
Liz Ann:
Honestly, there are so many of them but I’d say it’s the sentiment indicators that he either pioneered or really focused on that have always resonated most with me.
In fact, one of I think the most interesting responses he ever gave to a reporter who was in the office doing a long form interview on him, and these were the days where even when computers came into the mix, he still kept track of all of his indicators on that green accounting graph paper in pencil. He was really old school.
And this reporter asked him, “If you had to throw away all but one of your indicators that you’ve used over the years in the past currently, only one, you had to rely on just one to time the market, what would it be?” And right away he said, “[inaudible] bull or bear covers on Newsweek and Time.”
And that of course was before the internet, so it was the paper form of those magazines and he said, “That was the single best indicator was if Time or Newsweek or they both had bulls on the cover that during the same week that was at or near the top and vice versa with bears.”
So I think those sentiment indicators always resonated with me. When I first started within the first week, he came over to my desk and handed me a book I still recommend all the time, particularly to young people, is Reminiscences of a Stock Operator, and that’s all about sentiment and getting tips from your shoeshine guys. So those have always been the ones that really have stuck with me in my 37 years doing this.
Meb:
Listeners, if you buy that book, there’s a recent version where Paul Tudor Jones did either the intro or did a summary at the end that has a really nice chapter where he talks quite a bit in depth on some ideas that I think is really wonderful.
A couple things I love already in this podcast we’ve talked about microfiche, writing in pencils, things that this younger generation might not even know what microfiche is.
But Lou Rukeyser gave you a piece of advice that I’m now going to co-opt forever anytime we do interviews. Can you tell the listeners what he said to you when you were going on the show for the first time?
Liz Ann:
Yeah. So I was going on for the first time and for the more seasoned people like maybe you and me that remember the show and remember Lou, the structure of the show was Lou would come out, do his opening monologue for, I don’t know, five to seven minutes, then he’d walk over to a conference table with the three panelists, the regular panelists that were on that night and then everybody would get up and go over to the sofa area to interview the special guests.
So I ultimately became a panelist but my first time on the show was as the special guest. This was in 1997. I had only done I think maybe two TV appearances prior to that. So I was a real neophyte and not quite still a deer in headlights but close to it.
And before the show started, I was meeting him for the first time, all the pleasantries and then he said, “Are your parents still alive?” I said, “Yes.” He said, “Are they finance people?” I said, “Nope, far from it.” And he put his hands on my shoulder and looked me right in the eye and said, “Okay, when you come out and do the interview with me, get them to understand what you’re talking about.” And that has so stuck with me since that point in time.
And I find what’s interesting is that more often than not, if somebody is kind enough to send me an email or come up to me after an event or walk up to me in an airport and they’ll say, “I really appreciate that you write in a way or speak in a way that people can understand.” More often than not, it’s people on the more sophisticated end of the spectrum, not the mom and pop.
And 37 years doing this, I’ll admit if I read something that clearly the person wants to show how smart they are and they’re going way back at history and I’m scrolling to get to the point, we don’t have time, we’re inundated with this stuff, there’s no reason to make it harder than it needs to be.
Meb:
Yeah. A hundred percent agree. My litmus test for a chart often and this gets into my economic friends where it should be pretty obvious within a few seconds what the chart is telling you. And so many I look at and I’m like, “If you gave me an hour, I cannot figure out what this is trying to say, it should be intuitively obvious.” But I hear you. There’s no more field, maybe legal, that’s more jargony than our world. So much of it is unnecessary.
All right. So we got a lot of jumping off points I want to talk about. You put out a lot of great content. One of the recent pieces you were talking about is this concept of rolling recessions. Can you elaborate what you mean by that?
Liz Ann:
So not that every recession is the bottom falls out all at once, but there’s usually some sort of crescendo moment. Global financial crisis of course would be the Lehman point where everything really just melted. That clearly was the case with the COVID recession. It was a bottom falls out all at once.
But this is an environment very unique to the pandemic where the weakness has rolled through over a fairly extended period of time. And it’s not just within the economy but the manifestation in inflation statistics too.
And not that any of us want to rehash the early part of the pandemic but to just start the role, you go back to the point during which the massive stimulus kicked in, of course both on the monetary and the fiscal side, and that stimulus and the demand associated with it was forced to be funneled all into the goods side of the economy because services were shut down, we had no access. That was the launch for the economy coming out of the very short-lived COVID recession. It was also the breeding ground for the inflation problem that started to develop most acutely initially on the goods side of the equation, of course exacerbated by supply chain disruptions.
Fast forward to the more recent period, we’ve had the offsetting revenge spending in services but we’ve had recession conditions across the spectrum of a lot of consumer-oriented goods, housing, housing related, manufacturing, those have all gone into their own recessions. It’s just been offset by that later strength and services. It’s manifested itself in inflation where we’re in disinflation probably soon outright deflation in many of the goods areas but we’ve had that stickier later turn higher on the services side.
And to me, the debate of recession versus soft landing misses the nuances of this and that’s why I’ve been saying that I think best case scenario isn’t really a soft landing in a traditional sense but a continuation of the roll through such that if and when services starts to get hit, you’ve got offsetting stability or improvement in some of those other areas.
Meb:
You guys talk about all sorts of different charts and so we can get into a few or ideas. LEI is one that I’ve seen you mention. Is that saying similar or different? What’s LEI?
Liz Ann:
Yeah. It’s imploded. The leading indicators have absolutely imploded and we’ve never seen this kind of deterioration in leading indicators other than not just as a warning of recessions but in recessions, already in recessions.
Now the mitigating I think factors this time, number one, the LEI has more of a manufacturing bias than it does a services bias and that’s not because the conference board who puts out the Leading Economic Index is clueless.
It’s not that they don’t understand that services is a bigger driver of the economy, it’s the fact that the data, the components of the index which are more manufacturing driven are in fact the leading indicators and that’s where you see the cracks and the weakness first before it ultimately works its way into services types indicators and including the labor market. You’ve also got I think four of the 10 subcomponents of the LEI are financial related metrics like the inversion of the yield curve and stock prices.
And I think it’s that roll through. We’ve seen the acute weakness on the manufacturing and the good side clearly picked up by the leading indicators. It’s just the span of time before it hits, maybe it never does, the services side is just longer in this cycle.
I still think they’ll ultimately be right. If somebody said to me, “You just have to say yes or no, does the NBER eventually declare this now, down the road already, whatever this cycle, a traditional recession?” I’d say yes, but we’re not there yet.
Meb:
I just like the theory that Taylor Swift and Beyoncé are really just keeping the global economy afloat and having recently gotten to witness that in Los Angeles, I’ve never really quite seen anything like it.
Liz Ann:
I’m a rock chick, so I’m not…
Meb:
What would be your intro music if we said, “Liz Ann, you got to pick a song as like a walk off.” What would you be playing? Stones?
Liz Ann:
Well, my favorite is Led Zeppelin by far.
Meb:
Okay.
Liz Ann:
U2 is up there. Stones is up there. Probably Lid Zeppelin, U2, and Stones.
And I think you know that all of my written reports for decades have had rock song titles associated with them.
Meb:
I think my favorite is Your Time is Going to Come. Is that even the name of the song? But I love that song more than anything.
Liz Ann:
Oh, yeah. I’ve used a lot of Led Zeppelin songs for… Song titles.
Meb:
I think that’ll be the title of our waiting on Gado foreign stock market performance relative to the U.S. that we probably have had on repeat for the past 10 years waiting for something to outperform the U.S.
Liz Ann:
Well, Japan’s doing okay.
Meb:
Yeah. Well, we’ll get to equities in a second. There’s two other sort of economic type of macro topics that I think everyone talks about and scratching their heads and people love to debate and we’ll hit both of them, but housing and then of course the fed and I’ll let you pick which one you want to hit first.
Liz Ann:
So housing, I’ll start with that.
I think really important is differentiating between the existing side of the ledger and the new home side of the ledger and then separately single family versus multifamily.
There’s so many crosscurrents happening across that spectrum that much like has been said historically that you have to look at housing locally to understand what the local economics are driving the market that you should never look at the real estate market housing monolithically other than maybe a period like ’05, ’06 and the blowing up of the housing bubble and then the subsequent bursting of the housing bubble. It was a monolithic thing but less about regional differences, metropolitan differences. This time, it’s a big difference between what’s going on in the existing market and in the new home market.
And part of the reason why there’s been resilience in prices more so than what we saw, say, in ’05, ’06, the subsequent bursting of that bubble prices imploded not the case this time is just the dynamics of what’s gone on in the existing market, the fact that I think it’s 60% of mortgage holders have a sub 4%, even a decent share of that sub 3%, which effectively means they’re locked into their homes at that low mortgage rate.
It also explains why they haven’t succumbed to the pressure of higher mortgage rates because they’ve locked themselves in but it’s kept that supply off the market which has pushed a lot of buyers into the new home market and maybe why higher mortgage rates hasn’t crushed that although sales across the spectrum of existing and new did compress in the 30, 40%, it’s just prices haven’t come down significantly.
But in the new home sales market, there’s just been a lot of creativity being used in terms of financing some of these purchases including concessions provided by the home builders themselves. So it’s just mitigated the more basic black and white impact of mortgage rates and a lot of the improvement that we’ve seen in housing recently has been much more concentrated on the new home side of things, not the existing home side of things. So I think it’s really important to do that differentiation.
And then on the multifamily versus single family, by the end of this year, we will have added more supply into that multifamily market than any time we’ve seen since the early 1970s. So what had been an undersupply problem a few years ago now has a potential to be an oversupply problem which means you’re just going to have to fine tooth comb a lot of this housing data to get a true picture of the story because of that differential between existing and new, between single family and multifamily, and then as always, the unique characteristics of various metropolitan and regional areas and what the economics are of those local areas and what the supply-demand fundamentals are.
Meb:
Don’t fight the fed, all time classic Zweigism and this period, although maybe totally unique, has been pretty dramatic in the rise in interest rates and they say they’re chilling now. What’s the path forward best guess? What do you think the fed’s thinking about? What do you think they’re thinking about doing in the future?
Liz Ann:
What surprised me with the hotter than expected retail sales numbers yesterday and IP today is it didn’t really move the needle on probabilities associated with the September or even out meetings. So it still looks, if you rely on something like the CME FedWatch Tool looking at fed funds futures, still a decent chance that the fed is in pause mode, that they’re done.
I think where the disconnect still exists is the expectation of pretty aggressive rate cuts happening next year. Now that’s not out of the question but the view about significant rate cuts next year is often wrapped into the bullish, Goldilocks, almost no landing scenario.
And there I think lies the disconnect where the all else equal meaning if we continue along this path of disinflation and whatever metric it is, PCE, CPI, PPI, core of any of them, supercore, X shelter, whatever, derivation of all these inflation data you want to look like…
Let’s say they get down to maybe not to the fed’s target but close enough to it. But if there’s no further cracks in the labor market and let’s say, Atlanta’s fed’s GDP now is anywhere near accurate and it’s now cast not a forecast, but an update today at 5.8%, what prompts the fed to start cutting aggressively? I understand that if we continue disinflation and even if they’re in pause mode, that means real rates will continue to go up.
But I think under Powell in particular, they’re not using the playbook from the 1970s in the sense that they believe the conditions that existed then mirror the conditions that exist now. But what I think they really want to make sure they don’t repeat is the fits and starts the victory declarations three times easing policy only for inflation to be let out of the bag again and then the scramble. And that’s what led Paul Volcker to have to pull a Paul Volcker as we now say, where those fits and starts.
So that’s where I think the disconnect is. I think it’s probably a maybe not higher than here, but here for longer. And in particular, if you look at history, the span between a final rate hike and an initial rate cut, the narrower spans were tied to much weaker labor markets than the longer spans. So that’s the way I’m thinking about it.
Being in pause mode doesn’t surprise me. I wouldn’t be surprised if the fed is done, but they may have to start pushing back on this market expectation of five rate cuts coming next year.
Meb:
You were talking about stock market performance, I believe where you had a quote where you said, “There’s extraordinarily wide range of outcomes in the 14 rate hike cycles since 1928. Generally, in the range of minus 30 to plus 30 over the span of 12 months following the final hike.” That’s a pretty wide outcome.
Liz Ann:
Which is why… What made me put that report together… I don’t quibble with somebody saying, “Well, the average performance of the S&P around or after the final rate hike is…” That’s factual, that’s math.
But it was the first time I heard somebody say, “The typical performance of the market…” And I thought, “What? If you only have 14 in your sample size and the range, at least in terms of you pointed out one year after the final hike, you had a range of outcomes from a rounding. Market down 30% to market up 30%. By definition there’s nothing typical. And if you were to do an average, by definition, none of the outcomes actually look like the average because when you have a small sample side with a wide range, shame on anyone that doesn’t add that into the mix of discussion as if there is some typical pattern or average.”
And then I don’t remember who first said it. I can’t give credit to Marty for this one. I don’t know who first said it. But analysis of an average can lead to average analysis and I think that that is so brilliant and when you plug in the word typical instead of average, it just sends such an inappropriate message that there’s some normal path for the market around fed cycles and it just shows that, yeah, it’s an important factor, don’t fight the fed. But there’s so many other things that go into how the market and why the market behaves the way it does.
Meb:
The way we try to describe it is example we give is from Christmas vacation where we say, “Look, on average when your crazy cousin Eddie shows up, he’s probably well-behaved, but you may get the guy who’s unloading his RV septic tank in your sewer or you may get the guy’s dog knocks over the tree. You never know.” So I think we usually use that when we were talking about gold as a diversifier in down stock market months where sometimes it shows up and does a great job. On average, it diversifies but it could be anywhere.
All right. So let’s walk over a little bit towards everyone’s favorite, the stock market, which on average the market cap waiting has been romping and stomping this year after a pretty bad year last year. What’s it look like to you? Summer is quickly closing for us and everyone’s getting back to biz which usually means more eyes on the screen. Is everyone just going to mail it in for the rest of the year and call it a year?
Liz Ann:
I don’t know about that. August is always a tricky month when it’s the month that we all assume and hope everyone’s chilling on the beach. But it’s when some of the most tumultuous things have happened historically. And I’m not one that relies on things like monthly patterns or seasonal patterns to try to time markets. That’s just silly.
But there has been a lot of common complacency, if not outright, froth in many of the sentiment indicators until recently. In fact, I think this consolidation period, whatever you want to call it, tech sector down 8% or so and Nasdaq down 6%, I think that’s somewhat healthy because sentiment was getting quite frothy and the market performance had narrowed it to such a significant degree as we started June of this year that I think that in and of itself was a risk.
Going back to the low in October, at that time, the conditions actually looked quite healthy for the rally we subsequently saw. Even though the indexes like the S&P and the Nasdaq in mid-October last year were taking out on the downside their prior June lows. Under the surface, you were seeing improved breadth, so positive divergence in technical terms, and that really carried to the early part of this year.
Then you saw breadth roll over a little bit in the process of going to this heavy concentration of the mega cap eight, the magnificent seven, whatever grouping you want to look at, and it was such that on June 1st of this year, it wasn’t just that those small handful of stocks really represented more than all the performance but only 15% of the S&P’s constituents were outperforming the overall index over the prior 60-day period and at least as far back as data that we have, that was an all-time record low.
To see a bit of convergence where you continue to see some grinding improvement down the cap spectrum more spread out away from that small handful of names while you see some profit taking in those names kind of convergence I think is a relatively healthy development.
The one rub right now is that all of the move off the October lows was multiple expansion with no contribution at least yet from the denominator in the PE equation. Now that you’ve got yields moving back up and breaking out on the upside, that is a bit of a disconnect with the valuation expansion that we have seen. And I think that’s another reason for a pause to assess whether the expected pickup and earnings growth by the end of this year is actually a possibility and then maybe you can justify what became pretty rich multiples.
Meb:
So what do you think? Is it going to be… You talk a little bit about lending standards, earning growth for the second half. Do we think earnings growth is going to flow through or…
Liz Ann:
It’s hard to see the scenario under which earnings growth goes back into double-digit territory by the fourth quarter.
I think what’s happening unique in this cycle is that analysts are pretty reticent to make adjustments to the out quarter estimates that they have on companies. If you go back to the first year following the outbreak of the pandemic, you had a record percentage of companies not just guide down but just withdraw guidance altogether. I just said, “We have no clue, we’re not going to even attempt to provide guidance to analysts. So basically, you’re on your own.”
Now I think although we have a lot of companies in our back to providing guidance, I think many companies have use the pandemic, not as an excuse, but as a basis for not going back to the old ways of precision, to the sense around quarterly guidance. More companies you’re hearing saying, “Look, this is not how we run our business. So we want to back away from that to some degree.”
And so I think what that’s had the result of, in addition to all these macro uncertainties, I think analysts are closer to the vest in terms of the out adjustments. We’re just finishing second quarter earning season, they’re tweaking third quarter estimates but they’re not really doing much yet with fourth quarter estimates or into next year until maybe next quarter when they have more color from the companies of the stocks they cover. So therefore, I think those out estimates are maybe not all that reliable.
And the other thing that’s interesting about this earning season is the beat rate was very strong, close to 80%, that’s well above average. The percent by which S&P companies have beaten is I think 7.7 or 7.8, that’s well above average. However, revenue beat rate is well below average.
And what I think the view has been is there’s this shift of eyesight to not just bottom line but also top line and also looking at the differential between nominal and real.
So you’ve got nominal revenue growth that’s now nil for the S&P, in real terms, it’s negative which you can infer if you’ve got a lot of companies beating estimates with no top line growth, it means that that beat is coming all from cost-cutting which I think helps to explain not just this consolidation period in the market but the fact that the companies beating their stocks are underperforming the typical next day performance.
So I think there’s just some interesting things going on if you peel a layer or two of the onion back that helps to explain some broader market weakness but some of the action around what would on the surface seem to be great numbers in terms of the beat rate and the percent by which companies have beaten.
Meb:
Are there any particular sectors or styles that jump out at you? This could be traditional value versus growth. It could be energy or utilities or tech. Everyone’s hot and heavy.
Liz Ann:
We’ve been sector neutral for more than a year feeling that factor type investing makes more sense in this environment than monolithic sector-based investing. So screening for factors or characteristics. And we’ve had an emphasis on a quality wrapper around factors. So self-funding companies, companies with actual pricing power, strong balance sheet meaning low debt, higher cash, positive earnings revisions, lower volatility type companies, and really think that you should apply the screening of factors across all sectors, that there’s enough volatility in sectors and opportunities that can be found that it’s I think more appropriate to take a factor-based approach than a sector-based approach.
And you’ve probably seen this. More and more research firms, some of the big Wall Street research firms are devoting a lot more time, attention, and resources to this factor type work that I think is in part because we’re up off the zero bound finally after being there for much of the time since the global financial crisis and that ZIRP, NIRP outside the United States environment was one of the lack of price discovery and capital misallocation and burgeoning support for zombie companies.
And I just think the return of the risk-free rate means we now have price discovery again and fundamentals are getting reconnected to prices. Active management is at least maybe on a more level playing field relative to passive. That has been the case in many years other than first half of this year where cap weight soared again. Last year, we saw equal weight starting to do better and all of that is wrapped into the same story. So we’re going to continue to probably spend more time focused on factors.
The growth value thing, I love that question. Do you like growth or value or what do you think about it? But what drives me crazy is when somebody gives an answer that’s just as simple as, “Well, I like growth,” or “I like value,” or “I think value’s going to work.” And I always think, “Well, what are you talking about when you talk about growth and value?” And I think there are really three ways to think about growth and value.
The way I tend to think about it is the actual characteristics associated with growth and associated with value. Then there’s the preconceived notions that people have of what’s a growth stock and what’s a value stock. Well, tech, yeah, that’s growth and utilities or energy, that’s value. And then most interesting particularly this year is what the indexes hold that are labeled growth and value.
And really stark is what happened this year with the two different timeframes associated with the rebalancing that happen among the two big growth and value index providers. So S&P has four growth and value indexes. So does Russell. Now Russell is used more as benchmarks but S& P is obviously a well-known index company. So therefore indexes are S&P pure growth, S&P growth, S&P pure value, and S&P value.
If you’re in their regular growth or value indexes, you can also be in the other, you can be in S&P growth and you can be an S&P value which makes sense because there are stocks that have both characteristics. However, if you’re an S&P pure growth, you don’t overlap into value and vice versa, the value.
So S&P does their rebalancing in December every year, December 19th to be precise just this past December.
So here’s what happened. December 18th, S&P pure growth, I’m just going to use that as an example, was 37% technology and all eight of the mega cap eight were in S&P pure growth. On December 19th, only one of the eight was still in pure growth. The other seven moved into a combination of regular growth and regular value. The only one left in pure growth was Apple.
As a result of that rebalancing, technology went from being 37% of pure growth to 13% of pure growth. Energy became the highest weighted sector. Healthcare became number two.
Why energy? People think of it as value. Well, that’s where all the earnings growth was in the prior year. It’s the only place where there was earnings growth last year.
Well, fast forward to the end of June, when Russell did their rebalancing, energy was no longer displaying growth characteristics. So they did the rebalancing and there wasn’t much movement. So as a result, year to date, Russell 1000 growth is up I think 27%. S&P pure growth is up 2.7%.
So I always say, “What are you talking about when you talk about growth and value? Are you talking about the characteristics? Are you talking about your preconceived notions or are you talking about the indexes?” And if people say, “Well, the indexes. I’ll buy a growth index, it doesn’t matter.” Well, you better know what you’re buying.
And then conversely, since the beginning of July, now, pure growth, S&P pure growth is ripping again because the energy stocks are doing well and they just happened to still live in pure growth because the rebalancing was in December.
So that’s why we’ve never made tactical recommendations, outperform or underperform, on growth versus value because it requires a more nuanced description of what you’re talking about when you’re talking about growth and value. And our factor-based work has a blend of both growth-oriented factors and value-oriented factors.
Meb:
It applies so much to so many investors. We talk to or you read articles and they really don’t get past the headline. The name of an ETF, it’ll say something. ESG has obviously been in the news a lot for… You look at the various ESG indices and some own some stocks and some kick them out, yada, yada, yada. But you look at like, “Oh, cool. I’m going to buy this whatever fund.” And then you read the prospectus and you’re like, “Well, that’s actually not at all what this says it is.” And so I think a lot of people get surprised when they actually look through that obviously and this is very clear, but the methodology matters and your definitions matter.
Liz Ann:
And the other interesting thing about growth and value is that there was a point last year where I don’t even know if it’s still the case, but utilities as an S&P sector were trading at premium multiple to the S&P to a degree that never before has been seed. So more expensive relative to the index than ever.
Well, utilities still live in the value indexes. They’re not growth stocks, they’re never going to be rebalanced into the growth indexes. But just because they live in the value index or the value indexes doesn’t mean they offer value. They’re just expensive stocks that happen to be housed in the value index. It’s because they’re not growth stocks.
So what often happens is if you don’t scream well on those growth characteristics, you automatically get lumped into the value indexes but that you don’t necessarily get that value there.
Meb:
You alluded to Japan earlier. Speaking of value, Uncle Warren Buffett has been flying around Tokyo and hanging out and buying up Japanese stocks. We can use that as a jumping point for what are the equity markets outside of the U.S. look like. Everyone obviously is always talking about China, what’s going on with their equity markets, and foreign markets in general have been in the shadow of the U.S. markets for decade, 15 years longer maybe. What do you guys think about when you’re looking at outside the U.S. and what’s going on in the foreign equities?
Liz Ann:
I don’t know if you’ve met him or know him or my colleague Jeff Kleintop who is my counterpart on the international side of things. So now I’m dipping into his bailiwick here but we’re all on the same broader team, so I certainly can parrot some of the thinking there.
And for the better part of the past year and a half, we’ve been saying diversification outside U.S. equities makes sense again. That’s different from saying, “Sell all your U.S. equities and back up the truck and load up on nothing but international.” But there was such a pushback on why you would have any international exposure because the U.S. was the only game in town. And that is already ebbing. Last year was a good year for many non-U.S. markets.
Our bias has been developed international versus emerging markets. And within developed, our bias has been more toward Japan.
And in part the reason for a bias against emerging markets is a bias against China because of what we’re seeing in earnest right now which is a very short-lived reopening surge in the economy that’s giving way to some serious long-term challenges very acutely in the property market but just their demographic challenges are I think still less well-known than they should be because it’s just a massive headwind for their economic growth and standing in the global economy. And we’re seeing it in terms of just the big drop in percentage of imports to the U.S. from China relative to other places around the world.
So again, to go back where I started, we’ve just been saying, “You want to have international exposure that there’s going to actually be a benefit to having that diversification.” And you do tend to go in these long cycles of U.S. dominance and then international dominance and it tends to correspond with major global economic cycles. And we think we may be at the beginning of one of these cycles where having that international mix is going to be a diversification benefit.
Meb:
Yeah. We’ll see. I’ve been waiting on that for a while.
A lot of the conversations I’ve been having over the past year, and this is my interpretation of it, this is not what the advisors say, but this is my modern interpretation is they say last spring, the summer I say, “Look, I want to T-Bill and chill.” I got this yield that we haven’t had in a really long time and it’s almost like found money. And so many clients are like, “Oh my gosh, I’m going to get 5% risk-free. Come on.” And so we talked to a lot of people to say, “We’re just going to chill out.”
Fixed income, you referenced this early, what a weird time negative yielding sovereigns, U.S. briefly looked like it was going to head that way. Here we are a few years later and…
Liz Ann:
There’s income and fixed income again.
Meb:
Yeah. Does that market… Do you guys spend much time looking at the fixed income opportunity set? When you say fixed income, there’s a lot.
Liz Ann:
Yeah. So Jeff is my counterpart on the international side. Kathy Jones is my counterpart on the fixed income side. So she’s our chief fixed income strategist. And her team was really optimistic about bonds coming into the beginning of this year, bonds are hot again.
And the more recent commentaries have been around the recommendation to consider lengthening duration particularly when you see the longer duration areas like the 10-year move up and beyond the high end of the range, you probably want to lock in those yields and as enticing as a five and a quarter percent yield is on a much shorter term treasury, there’s the reinvestment risk component.
So that’s been the recommendations that Kathy and her team have had specific to duration within treasuries, stay up in quality, be really careful about high yield compressed spreads probably is not a permanent situation. There is some risk there.
But back to the relationship with the equity market for such a long period of time, income oriented investors in a ZIRP world were forced into the equity market to generate income and now they’re not. They can stay in the safety of treasuries which interestingly helps to explain why the big dividend yields within the S&P are not the big outperformers or the underperformers right now because that cohort of investors that wants at least a portion of the portfolio being that income generator, it can now occur in the safety of treasuries without either having to go out the risk spectrum on the fixed income side or go into the equity market.
And I think that we’re maybe in an environment similar to the 1990s in the sense that the 1990s when you had a higher interest rate regime, you had a lot of money that was going into money market funds while the stock market was also doing well. And that just shows that there are different pockets or cohorts of money. And I think this move away from, and I’m going to say 60/40 and I don’t mean that literally or precisely 60/40, 60 stocks, 40 bonds, that’s one allocation in two simple asset classes.
But the notion of having both equities and fixed income in a portfolio was questioned because it was a brutal year last year. Well, that doesn’t tend to repeat itself year after year. And we think that bonds will continue to be a diversifier and there are a lot of opportunities now for retirees, for income oriented investors that lament it having to go out the risk spectrum in order to get any semblance of income and they don’t have to do that anymore.
But that reinvestment risk really has to come into play when making that duration decision. So the shiny object of more than 5% yields on the very short end, you do have to consider what happens when those mature.
Meb:
We’re going to wind down with a couple of broad topics and questions.
One of your quotes that we love, excuse me, not your quotes but quotes I think you like and I, so we love, and you can tell us who said this, but the very famous, “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.” Who said that?
Liz Ann:
Sir John Templeton, who by the way, I had the great pleasure of meeting on Wall Street Week. I was a panelist on an evening that he was a guest and that was one of the highlights of my career was meeting him. And I think there’s nothing more brilliant said about a market cycle than that.
Meb:
I like to think about it often and to me, the better part of this year felt like market’s going up after a really rough year last year and the vast majority of people I talked to not believing it or maybe it’s just like the doomers hoping it was going to continue. And so maybe… Where would you put us in this?
Liz Ann:
This is the ultimate wall of worry year. Markets like to climb a wall of worry. And I also think that this idea that the market is now fighting the fed which it’s never supposed to, well, it didn’t last year.
But what you do look back in history is the market generally starts to rally in anticipation of the fed finishing the cycle. Sometimes, you can roll over again, particularly if the elusive soft landing doesn’t materialize but a pause or a pivot rally is not uncommon for the market. But the other adage that is apt for this year is the wall of worry.
Meb:
Yeah. I think this is you so you can correct me, “Neither get in or get out are investing strategies. They simply represent gambling on moments in time. Investing should always be a discipline processed which should include periodic rebalancing.”
We talked to so many investors and they say, “Meb, I’m thinking about getting back in the market,” or “I want to buy managed futures fund. Which one do you think I should buy?” Or “The S&P list’s expensive, should I get out?”
And to me, this behavioral binary… In-out is one of the most detrimental ways to think about the world. Is that what you meant by this or do you mean something else? Okay.
Liz Ann:
That’s a hundred percent what I meant about that. That get in, get out. Those are just gambling on two moments in time and that’s not what investing is. Investing is a discipline processed over time.
And all the greats that we’ve talked about, whether it’s Marty or Sir John Templeton or the founder of my company, Chuck Schwab or Warren Buffett, the list goes on and on. I don’t know any of them that became successful investors with a get in, get out approach. It was a disciplined process over time. And that’s what investing should be about.
And the beautiful discipline of rebalancing is it forces us to do what we know we’re supposed to which is a version of buy low, sell high, but add low, trim high. When left to our own devices, more often than not, we do the complete opposite. And your portfolio is telling you when to do something. You’re not relying on your ability to make a top and bottom call or listening to me try to do that. And it’s why I don’t try to do it because I can’t. And nobody can, by the way.
And there’s just too much focus on the get in, get out. And it’s why some of the exercises that the institutions I think forced their strategists to do like you’re in price targets, I just think that that’s… For our $8 trillion of individual investors, I just don’t see how that is a relevant metric because no one’s right.
Meb:
Yeah. We often tell investors you have to have a plan and a system ahead of time.
Liz Ann:
Hundred percent.
Meb:
If you don’t and you’re really stressing about a decision of in-out, I say, “Look, you can go halfsies or sell half of it.” But that’s the least satisfying answer to people because they want to gamble on the outcome and they want the emotional excitement of being right or looking back and saying, “Ah, I knew I should have sold.” But in reality, it usually ends up the opposite.
Liz Ann:
The emotional side is what crushes people. I always say, “If you can figure out whether there’s a large or small gap between your financial risk tolerance and your emotional risk tolerance, that’s a key to success.”
Meb:
When you look around the investing landscape, your professional peers, what is one thing in particular that they would not agree with you on or said differently? What’s a belief you have that most people wouldn’t agree with you about? It could be a style, a way to think about markets, an opinion, an indicator, anything.
Liz Ann:
I think valuation is a sentiment indicator or better put an indicator of sentiment. And we think of valuation as this fundamental metric that’s quantifiable and to use just PE ratio as a simple example because there’s lots of different valuation metrics, but we can quantify the P, we can quantify the E, particularly if it’s trailing earnings, they’re there, we know what they are. Forward earnings, you have a consensus number for foreign earnings. You can do the math, you can compare it to history. You can even bring interest rates and inflation into the mix to see what ranges have been.
But the reality is that there’s just time in the market that investors are willing to pay nosebleed valuations like in the late 1990s and there are times where investors don’t even want to pay single digit valuations like in early ’09. So it’s an indicator of sentiment.
It doesn’t mean I don’t look at valuations and do all of that same analysis, but when push comes to shove, it’s an indicator of sentiment more than anything else.
Meb:
That might be my favorite statement or quote of yours so far.
I remember I was sitting on a panel, this is many years ago, so I can’t remember if it was a panel or I was interviewing him or we were both just chatting. Ralph Acampora was a very famous technician, listeners, but he was talking about valuation and he was trying to…
He is very animated and he was chatting with the audience and he put this up on a screen and he said, “PE ratio.” He said, “Look at this. What’s in the numerator? It’s P, it’s price.” He is like, “This is the determining factor of valuation is where the price goes. And if you do a lot of this sentiment and price, a great example would be chart the S&P, chart sentiment, and then chart also percentage of an equity portfolio allocated to stocks. And they all move together which makes sense. As price goes up, people own more. By definition, that’s mark cap weight. People get more excited because they’re richer,” and on and on. And so this concept you just talked about I think is spot on.
Your most memorable investment, not best, no worse, could be, but just one that’s seared in your brain is a trade or investment that you’ve made over the years that you remember more than anything.
Liz Ann:
It manifested itself in a real estate purchase but it also worked its way into some writing that I did.
So it was March of ’09, it was the Friday night before the bottom, my husband and I, this is when we were living in Darien, Connecticut surrounded by Wall Street people, lots of really brutal experiences through the financial crisis. Several friends that worked at Lehman and Bear Stearns.
But we were at a dinner party at a friend’s house, I won’t name a name, but this is somebody that had worked on Wall Street for three decades at this point and 11:00 dinner was over. Stragglers left including us and the host said, “Liz Ann, I don’t envy your position.” And he paused for effect. He was a dramatic guy. And I said, “What do you mean?” He said, “Well, working at Schwab, doing what you do, I don’t think there will ever be an environment again in our lifetime that individual investors will want to buy stocks and it makes me question their survivability of a company like Schwab.”
So I made some sort of, “Well, I begged to differ.” We get in the car, my husband looked at me and said, “I’m guessing you heard it.” And I knew immediately what he was talking about. I said, “The bell ringing?” He said, “I knew you were thinking that.”
And I reached out to my friend over the weekend. I said, “I’m not going to mention your name, but can I share the story in something I’m going to write?” And it was a report I titled Here Comes The Sun. And it was a shoeshine guy, but in the opposite direction, last man standing. There’s no one left in the despair mode. This is what bottoms feel like.
But I also said to my husband, we had been vacationing in Naples, Florida for many years. My sister has lived there for many years. My husband wanted to buy in ’04 and ’05, ’06, and I said, “Uh-uh. Market’s going to crash. Terrible housing market.” So I said, “Now, we buy.” So we bought our house in Naples, Florida in April of ’09. So that was definitely the best investment that we ever made. It just happened to be in the real estate market.
Meb:
Yeah. Those conversations I think worth gold, but also the showcase, the emotional side of this that everyone is suspect to, that you can’t control it. But it’s worth taking note.
Liz Ann, this has been a tour de force. It’s been a blessing. Thank you so much for joining us today.
Liz Ann:
Thank you. What a fun conversation.