In this podcast, Motley Fool senior analyst John Rotonti talks with Liz Ann Sonders, chief investment strategist at Charles Schwab, about topics including:
- The "mother's milk" of stock prices.
- How this market is like the 1970s and post-WWII and also completely unique.
- One common rebalancing mistake that investors often make.
To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.
This video was recorded on Sept. 18, 2022.
Liz Ann Sonders: The last four months, according to the payroll survey, the economy has added 1.68 million jobs. According to the household survey over that same four-month period, the economy has lost 168,000 jobs. One of those is a more accurate story. My guess is the household survey only because it's always been more accurate at turning points.
Chris Hill: I'm Chris Hill and that's Liz Ann Sonders, chief investment strategist at Charles Schwab. Motley Fool senior analyst John Rotonti recently caught up with Sonders to talk about what drives stock prices, the wide-ranging signals from the labor market, why economic cycles are getting shorter, and how investors should respond.
John Rotonti: Let's dive right in, Liz Ann. What drives stock prices over time?
Liz Ann Sonders: Believe it or not, I think it's probably sentiment more than anything else. You and I probably talked about this. I think the greatest thing ever said about the market was probably the most famous quote of Sir John Templeton's of bull markets are born in despair, grow on skepticism, mature on optimism, and die on euphoria. I think that's such a brilliant way to talk about a market cycle. The lack of any fundamental economic valuation terminology in there, I think the reality is that especially at extremes, at major turning points, you really could point to sentiment more than anything else. That doesn't mean all of those other factors aren't important. But the other thing I'd say is when it comes to the fundamentals, we have to remember that the stock market tends to lead major turning points in the economic cycle. It also tends to be more highly correlated to other leading indicators: some within the housing markets, some yield curve related, ISM manufacturing, new orders, that data. You tend to see those leading indicators move to some degree in sync.
John Rotonti: When you say sentiment, are you referring to the emotional state of mind of a market?
Liz Ann Sonders: Sentiment can be measured both by attitudinal surveys and that would be the emotion as expressed in a survey. Are you feeling bullish, are you feeling bearish? That would be survey data like, AAII, American Association of Individual Investors, they do their weekly survey. It literally just asked, are you bullish or bearish? Are you neutral? You can look at attitudinal measures like investors' intelligence, which measures the attitudinal, the opinions of newsletter writers and advisors. But then there's also behavioral sentiment measures. Everything from the put-call ratio to fund flows, to move in and out of bull- and bear-type funds, what the speculators are doing in the futures market. I think it's important to look at a collection of sentiment indicators, making sure you're looking at both attitudinal measures and behavioral measures. Because there are times in fact, I think we're in one of them right now, where what investors are saying and what they're doing aren't fully connected. Looking at that collection I think is important.
John Rotonti: Love it. We just talked about that Templeton quote and how sentiment really drives stock prices, at least in the short term. But that quote, as you said, had no fundamental factors in it. My question now is, what are the macro factors, if any, that are most correlated with stock price performance over time, and what are the macro factors that you think stock investors should pay closest attention to?
Liz Ann Sonders: We know that as I forget who originally said it, earnings are the mother's milk of stock prices. But clearly, there's that connectivity, corporate earnings and stock prices. What tends to be most highly correlated is the year-over-year rate of change in earnings with the year-over-year rate of change in the S&P. So it's more of a trend connection as opposed to the stock market peaks when earnings peak or the stock market bottoms when earnings bottom. It's that directional trend that matters. But there's myriad other indicators. The PMIs tend to be pretty correlated to what the stock market is doing, particularly on the manufacturing side, so ISM manufacturing is highly correlated to earnings, which in turn is correlated to stock prices.
But there's also differences that happen in each cycle. In this cycle in particular, because we're dealing with a 40-year high in inflation, trends in the liquidity environment, the whole notion of don't fight the Fed, even almost to today's moves in the 10-year yield and the yield curve, that's really been driving shorter-term moves in the market. You had the peak in the 10-year yield at 3.5%, exactly two days before you had the most recent bottom in mid-June in the equity market, and now the equity market has gone through some struggles recently in trying to break through moving averages. That to some degree corresponded with the move back up in the 10 year. I think interest rate and inflation conditions have had more of a correlation in a very different way than the past 20 years. We went through a 30-year period, '60s, '70s and '80s, basically where the correlation between bond yields and stock prices was negative because that was an inflationary backdrop.
When bond yields were going up, it was typically reflecting a worse inflation environment, not necessarily a better growth environment. That's a toxic brew for the equity market. Fast-forward to the 20 years preceding the pandemic, we had a positive correlation between bond yields and stock prices, because that was a disinflationary environment so when yields were going up, it was generally just reflecting a better growth outlook without that inflation bug in the mix, great environment for the equity market. You have to be flexible and understanding what drives markets. The housing picture, things like the housing market index by the NAHB, that tends to bottom not with every wiggle around the same time that equities do, especially if the economic cycle has been more heavily driven by housing. Like was the case in '05, '06, and to the financial crisis, and I think to some degree in this environment. I think the housing, not just data in terms of the economy, but as a proxy for when we're probably out of the woods from a market perspective, I think that has to be more in the mix maybe than in an environment that is not so driven by housing.
John Rotonti: Sixties, '70, '80s, inflationary period, more recent decades, disinflationary. Is there a historical period that you think is a good comparison to today's market environment of high inflation, Fed tightening cycle, rising interest rates, geopolitical tensions, and possibly slowing GDP growth, and what does this historical comparison tell you? Do you even find that making these historical comparisons are helpful as a strategist?
Liz Ann Sonders: They're helpful as a guide to look at various mixes of ingredients behind both an economic and a market cycle, but they're certainly not gospel. They don't provide a road map of perfection in trying to glean what's going to happen, either in the economic cycle or the market cycle. I think there are certainly shades of the late 1970s, early 1980s in terms of just the level of inflation and the reaction function on the part of the Fed; however, what ultimately needed to be done, of course, via Volcker was a massive move up in interest rates to purposely bring on what ended up being the back-to-back recessions in the early '80s to finally break that up-cycle in inflation. I think we're not in that environment. Certainly not yet anyway, but I don't necessarily anticipate we're going to get there, but the Fed, we're still in negative real rate territory.
That's clearly a difference relative to the 1970s. It's also the background conditions that were the drivers of the inflation we had in the 1970s. Very different demographic profile. We had a huge new influx of workers into the economy, a lot more women coming into the mix, there was less globalization, more unionization. There are just as many differences as similarities. Similarity is really just about the level of inflation and an aggressive Fed. I think there's also shades of post-World War II. I've been saying that I think the pandemic almost had war-like characteristics in terms of the implication it had for the economic cycle, both as the pandemic started and coming out. What the drivers were of inflation with supply-demand imbalances almost had some similarities to the post-war environment. I think there are shades of both of those in the mix when we think about the uniqueness of this environment.
John Rotonti: You mentioned that to break inflation in the '70s, early '80s rates, whether the policy rate, whether the Fed funds rate or Treasuries, had to go higher than inflation. Right now, rates are lower than inflation. Do you think we need to see real rates higher than inflation in order to get back down to the Fed's 2% target?
Liz Ann Sonders: Well, we don't even have nominal rates above inflation, let alone real rates, which are still in negative territory. I think ultimately what's probably going to happen is a convergence. Some retreat in inflation, maybe not across the board, but concentrated on the good side of inflation metrics. You're already seeing that. You've got somewhat offsetting upward pressure on the services side. You've got the stickier components like shelter. But I think we're going to see this downward force largely on the good side of inflation data while the Fed is raising interest rates. I don't think we're going to need a Volcker-type situation, but the fact that there's discussion still happening about this notion and narrative of a Fed pivot.
I frankly don't really understand all the ingredients of that narrative. Especially given that that view is typically expressed by some of the most ardent bulls, either about the market and/or the economy. This idea that either because of what the Fed is doing, because of the supply side easing up through natural forces, that we're going to see a significant downshift in inflation. Allowing the Fed to not just pull their foot off the brake, but actually moved back into cutting mode. That's where I think that narrative falls apart. Because I think an environment that suggests the Fed has to go from aggressive rate hikes to rate cuts, means something pretty ugly in the economic backdrop.
I don't think just because inflation has peaked and started to come down that the Fed is going to view that as a green light to go from hikes to cuts. It may be a green light to move from 75 or 50 down to 25, or even to go into pause mode. But reinitiating rate cuts even from the perspective of worrying that we're going to reignite inflation and/or just the credibility that the Fed has suffered by virtue of keeping rates at zero too long, not shrinking the balance sheet sooner than they did, I just think that the conditions that would lead to a cutting cycle go well beyond just inflation having peaked and coming down, would probably mean definitively a recession or an unbelievable riot in the financial markets that could potentially reignite the so-called Fed put.
John Rotonti: Personally, I agree completely. The pivot narrative confounds me a bit, and I even tweeted something about that yesterday. Love to see that I'm on the same page with you, Liz Ann. What are your thoughts on the current stock market valuation?
Liz Ann Sonders: Obviously, there's lots of ways to measure valuation. Even if you're talking about a P/E ratio, there's lots of varieties of P/E ratio: forward P/E, trailing P/E, five-year normalized P/E, Shiller cyclically adjusted P/E, so it runs the gamut. I often joke that if you looked at the full collection of valuation metrics inclusive of everything from the Buffett model to the Rule of 20, to the Fed model, to equity risk premiums, to earnings yield. At any point in time, I can hand one to the bull and one to the bear, and they'd have a perfect argument to support their view. Because it does run the gamut, especially in the unique inflation interest rate environment with interest rates still low and real rates low. That puts equities in a better light. Whereas if you were to look at a purely backward-looking long-term Shiller CAPE type, that still shows the market is quite overvalued.
But let's just talk about forward P/E, it's arguably the most common. In the case of the S&P, it peaked in this cycle, late 2020, early 2021, at around 27. That really wasn't the same excessive valuation, akin to what we saw back in '99, 2000 when the S&P also traded at a 27 multiple. Because what caused it to get to 27 in this most recent cycle was just the absolute pandemic collapse in E. That artificially popped the multiple up there. Then of course we had the benefit of just the huge surge in earnings off the pandemic low, and then this year's bear market, which ultimately as of mid-June brought multiples down to around 15. That was pretty reasonable unless you were in a sustainable, ultra-high inflation environment, then you could argue even that was a little rich.
Courtesy of the move back up in the market, obviously especially concentrated up the CAPE spectrum and down the quality spectrum. The forward P/E has gone up to 18, 19 depending on what earnings you're using. Now we're in a part of the cycle where forward earnings projections are coming down. I'd say 18 and change, probably not fairly valued unless inflation is really about to sink like a stone. Again, the rub is now the denominator is moving in the opposite direction of where it's been moving. I'd say valuation is not the No. 1 risk that the market is facing right now, but I don't think reflects the still to come further rolling over in both second half of this year, estimates for the S&P, as well as 2023, has got started, but I think there's more to go.
John Rotonti: As we see leadership from very defensive sectors like utilities, what is your recession checklist telling you? Are we in a recession right now? Did those two quarters of negative GDP growth in a row indicate we're in a recession? If you don't think we're in a recession, how likely do you think one is in the next year or so?
Liz Ann Sonders: Let me start by just reminding all the Fools out there that two quarters in a row of negative GDP is not actually the definition of a recession. The NBER has been the arbiter of recessions since 1978, and that's never been the rule, so to speak, that they use. It's a bit more nuanced. It's not as quantifiable as something as simple as two quarters in a row of negative GDP. The four components of the economy that they look at primarily are not coincidentally the four coincident indicators. It's payrolls, industrial production, the broad measure of business sales, and personal income. I do think a recession is more likely, and it may already be underway, and that's simply based on understanding how recessions are ultimately dated. When the business cycle dating committee at the NBER gets in the room and they say, OK, it's a recession, at that same moment, they tell the world when it started by month. In doing so, they go back to the peak in the aggregate data.
Given it's coincident indicators that they're looking at, and they go back to the peak, you don't get heads-ups from those indicators. In fact, in the case of something like payrolls, which is arguably the economic data point of late that has the non-recessions believers patting themselves on the back saying there's no way we can have a recession with still rising and strong payrolls. Well, that's actually just not true based on history. In fact, there are three or four recessions, including the mid-'70s and both in the early '80s where payrolls were still rising when the recession was ultimately dated as having already started. It's a coincidence indicator. It's also highly subject to revision. That's why at potential turning points in the economy, the household survey from which the unemployment rate is calculated, does a better job of picking up what's going on in the economy. For instance, the most recent payroll print of 528.
The reason why no economists had anywhere near that high a number was because every single solitary leading indicator of payrolls of the labor market was telling a much more dour story, unemployment claims, layoff announcements, the rolling over in job openings, etc. In addition, the household survey, said the last four months, according to the payroll survey, the economy has added 1.68 million jobs. According to the household survey over that same four-month period, the economy has lost 168,000 jobs. One of those is a more accurate story. My guess is the household survey, only because it's always been more accurate at turning points. I think it's probably the more accurate story. However, all that said, I'm not sure recession or no recession at this stage in the game matters more than the academic. If you and I were having this conversation on Jan. 3rd, and we're at all-time highs in the S&P and the most recent GDP report we had was for third quarter of last year, which was strong, then the recession/no recession debate would have been much more important to gauge whether, are we at risk of a bear market given that the market tends to roll over before the recession happens? At this point, you can argue the economy has slowed significantly, that's just simple fact.
Whether ultimately the NBER comes back and says, it was officially a recession, here's when it started, here is when it ended, I'm not sure matters that much. Even looking back at the history of bear markets with recessions or without recessions, meaning there was some overlap between the two cycles. There's not much of a difference in percent decline for the S&P. The average decline of bear markets ex-recessions is about 29%, with recessions, it's 32%. That's not a huge difference, the difference is more in duration. Recessionary bear markets have lasted longer historically, about 60% longer. I think the recession/no recession, maybe more important in terms of how long does it take for us to get out of this volatility cycle before we feel comfortable that, yes, we're indeed in a new up-cycle, both in the economy and the market. Long answer, but I think it's important.
John Rotonti: It's a beautiful answer. Bridgewater is the largest hedge fund in the world. The CIOs from Bridgewater recently wrote that they are seeing the "strongest near-term stagflationary signal in 100 years" and that could lead to "instability and volatility over the coming decade." What do you think are the odds we enter a prolonged stagflationary environment and how do you think investors should be positioned for possible stagflation?
Liz Ann Sonders: It somewhat depends on how precise a definition of stagflation you're using because the definition as borne out of the '70s environment was not just simply weak growth and high inflation. The "stag" part of it was much more concentrated in what was going on in the labor market and the high-end rising unemployment rate. To the extent you're using a simple definition of weaker growth, higher inflation as a broad backdrop, I think we're in that environment right now. We don't have that unemployment component, though. We may not have it to the same extreme or degree because I think there is still that low labor force participation, there are still that skills mismatch, there are still labor shortages. That I think is a big difference relative to the 1970s, when there was such a demographic influx of workers. I don't see a repeat of the '70s in terms of all the conditions that existed then that were embedded into that stagflation.
What I think is happening that's maybe bigger picture and more important is, No. 1, I do think this is a more inflationary, secular environment that we're in. I think that will be borne out if we are in a sustained environment of back to being a negative correlation between bond yields and stock prices, I think that would be one of the tells. I also think we are in the process of a secular shift back toward labor having more power versus the 30 years or so prior to this period where capital had the power over labor. I think that may be the most important secular shift. To the extent that that is happening, what it suggests, which is akin to the 1970s, is more economic volatility.
More geopolitical volatility, meaning probably shorter economic cycles, more frequent recessions, not necessarily deep brutal '07, '09 recessions but just more volatility in the economic cycle as labor wrests some power back from capital. You go in long cycles, you go in multidecade cycles. It just happens through a variety of forces. There may be people who think I'm making some political statement and this is not Republicans versus Democrats or conservatives versus liberals; it has to do with much larger global forces that I think are coming into play and maybe have gotten sped up by virtue of the unique forces associated with the pandemic. That's more of the way I think about the secular environment that we're heading into as opposed to just simply defining it as stagflation.
John Rotonti: For our last question, If we're entering possibly a period of more economic cycles but shorter-term, for investors that have a longer-term horizon, let's say 10-plus-year time horizon, what strategic principles would you share with them? What investing principles or portfolio management strategies do you think lead to long-term investing success?
Liz Ann Sonders: Diversification and rebalancing are always two of the most important disciplines. But I think the applicable nuances with both of them are relevant to talk about. I think diversification needs to be the lens that we use to look at the ways to become diversified, needs to be broader than just stocks, bonds, cash. Especially if we're in an environment where you've got that inverse correlation between bond yields and stock prices, which means a positive correlation between bond prices and stock prices. Making just this simple diversification that you were able to get with bonds as a counter to stocks, you're more limited in finding those opportunities if that negative yield stock price correlation persists, which suggests maybe you need to be a little bit more active, especially within the fixed income portion of the portfolio, maybe it needs to be greater consideration of inflation hedges or exposure to real assets. I think again, a broader lens in terms of diversification geographically, too, not putting all your eggs just in the U.S. basket.
I'd say that both on the fixed income side and on the equity side. The good news for individual investors is the ability to invest in broader asset classes, take more of that endowment approach is greater than it's ever been through vehicles like exchange-traded funds and the democratization of other alternative asset classes. We're not limited only to the stocks, bonds, cash allocation anymore. I think investors should avail themselves of those diversification opportunities. Then on the rebalancing side, with both more economic and probably stock market volatility, a lot of rebalancing strategies are done based on the calendar. For many individuals, it might be done just on an annual basis. I think, with considerations of additional turnover and what that means for things like your tax implications, all that has to be taken into consideration and that's what you hopefully sit down with an advisor to try to do but more volatility-based rebalancing.
Letting your portfolio tell you when it's time maybe to trim into strength or add into weakness to make sure your overall strategic asset allocation is not getting out of whack, portfolio or volatility-based rebalancing allows us to take advantage of volatility and work it to our advantage by quite frankly forcing us to do what we know we're supposed to, which is, I always say, add low, trim high, as opposed to buy low, and sell high. Because the buy low, sell high almost suggests in and out and I don't think get in or get out is an investing strategy. I think those are nuances around the tried and true. There's no free lunches in this business but the disciplines of diversification and rebalancing are about as good as you get. But there's ways to apply both of those maybe a little bit differently in a more volatile overall and secular environment.
John Rotonti: I love ending on that, stay largely invested. Add low, trim high, use volatility as your friend. Liz Ann, we can't thank you enough, you're a friend of mine, you're a friend of The Motley Fool and we hope we can speak to you again soon.
Liz Ann Sonders: I hope so too. It's always a pleasure. Thanks, John.
Chris Hill: As always, people on the program may have interest in the stocks they talk about and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.
