Motley Fool Money - Liz Ann Sonders on Economic Cycles, Stock Prices, and Investing Mistakes

Episode Date: September 18, 2022

Shorter economic cycles and more frequent recessions doesn't necessarily mean the downturns will be brutal. John Rotonti talked with Liz Ann Sonders, Chief Investment Strategist at Charles Schwab, about: - The “mother’s milk” of stock prices - How this market is simultaneously like the 1970s, post-WWII, and completely unique - One common rebalancing mistake that investors often make Host: John Rotonti Guest: Liz Ann Sonders Producer: Ricky Mulvey Engineers: Dan Boyd, Austin Morgan Learn more about your ad choices. Visit megaphone.fm/adchoices

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So 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. And my guess is the household survey only because it's always been more accurate at turning points. I'm Chris Hill, and that's Liz Ann Saunders, Chief Investment Strategist at Charle.

Schwap. Botley Fool senior analyst John Rotanti recently caught up with Saunders 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. So let's dive right in, Lizanne. What drives stock prices over time? 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 the probably most famous quote of Sir John Templeton's of bull markets are born in despair, growing skepticism, mature, and optimism, and die on euphoria. And I think that's such a brilliant way to talk about a market cycle. And 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. So it also tends to be more highly correlated to other leading indicators. Some within the housing market, some yield curve related, you know, ISM manufacturing, New orders, that kind of data. So you tend to see those leading indicators move to some degree in sync. And when you say sentiment, are you referring to the emotional state of mind of the market?

So 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 surveyed data like AIAI, American Association of Individual Investors. They do their weekly survey. It literally just asks, are you bullish, are you neutral? Then you can look at attitudinal measures like Investors' intelligence, which measures the sort of attitudinal, the opinions of newsletter writers, of 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.

So 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. So, looking at that collection, I think, is important. Love it. So 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. And so 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? So if you were, 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 quite.

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 two days moves in the 10-year yield and the yield curve that's really been driving shorter-term moves in the market. You know, you had the peak in the 10-year yield at 3.5 percent, 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 and trying to break through moving averages, and that, to some degree, corresponded with the move back up in the 10 years. So 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. So when bond yields were going up, it was typically reflecting a worse inflation environment, not necessarily a better growth environment. That's kind of 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 kind of bug in the mixed. Great environment for the equity market. So you have to be flexible in understanding what drives markets. The housing picture, things like the housing market index by the NIHB, 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 into the financial crisis, and I think to some degree in this environment. So I think the housing, not just data in terms of the economy, but as a proxy for, you know, 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.

So 60, 70s, 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, a Fed tightening cycle, rising interest rates, geopolitical tensions, possibly slowing GDP growth? And what does this historical comparison tell you? And do you even find that making these historical comparisons are helpful as a strategist? 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 roadmap 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 and interest rates to sort of purposely bring on what ended up being the back-to-back recessions in the early 80s to finally break that upcycle and inflation. I think we're not in that environment, certainly not yet anyway, and I don't necessarily

anticipate we're going to get there, but the Fed, we're still in negative real rate territory. So that's clearly a difference relative to the 1970s. It's also the background conditions that were the drivers of the kind of inflation we had in the 1970s, very different, 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. So there are just as many different. differences as similarities. Similarity is really just about the level of inflation and an aggressive that I think there's also shades of post-World War II. And I've been saying that I think the pandemic almost had warlike characteristics in terms of the implication it had for the economic

cycle, both as a pandemic started and coming out, what the drivers were of inflation with supply demand imbalances almost has some similarities to the post-war kind of environment. So I think there are shades of both of those in the mix when we think about the uniqueness of this environment. You mentioned that to break inflation in the 70s, early 80s, rates, whether the policy rate, whether the Fed Fund 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? Well, we don't even, you know,

we don't even have nominal rates above inflation, let alone real rates, which are still a 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. And 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 rate. So I don't think we're going to need a Volker 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. And 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 break, but actually move back into cutting mode. That's where I think that narrative sort of 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 the Fed is, 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 a 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. Personally, I agree completely. The pivot narrative confounds me a bit, and I even tweeted something about that yesterday. So I love to see that I'm on the same page with you, Lizanne.

What are your thoughts on the current stock market valuation? So, obviously, there's lots of ways to measure valuation. Even if you're talking about a PE ratio, there's lots of varieties of PE ratio. of PE ratio, forward PE, trailing, PE, five-year normalized PE, Schiller cyclically adjusted PE. So it sort of runs a gamut. I often joke that if you looked at the full collection evaluation 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 could 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, you know, Schiller Cape type, that still shows the market as quite overvalued. But let's just talk about forward PE. 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. And that really wasn't the same

kind of 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. So that sort of 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. And then you could argue even that was a little rich. Courtesy of the move back up in the market, obviously, especially concentrated up the cap spectrum.

and down the quality spectrum, the forward P has got up to 18, 19, depending on what earnings you're using. And now we're in a part of a cycle where forward earnings projections are coming down. So I'd say, you know, 18 inch change, probably not fairly valued unless inflation is really about to sink like a stone. And again, the rub is now the denominator is moving in the opposite direction of where it's been moving. So I'd say valuation is not not sort of the number one 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 2023s. That's started, but I think there's more to go. 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? And if you don't think we're in a recession, how likely do you think one is in the next year or so? So 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 recession 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. So it's payrolls, industrial production, the broad measure of business sales, and personal income. And 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. So when the business cycle dating committee at the NBER gets in the room and they say, okay, it's a recession, that's at that same moment, they tell the world when it started by month. And in doing so, they go back to the peak and the aggregate data. So given its coincident indicators that they're looking at, and they go back to the peak, you don't get heads up 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-recession believers,

sort of patting themselves on the back saying there's no way we could 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. And 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. So, for instance, the print, 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 him. much more dour story, unemployment claims, layoff announcements, the rolling over in job openings, et cetera, et cetera. In addition, the household survey, so 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. And 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 academics of it. you know, if we were, if you and I were having this conversation on January 3rd, we were 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, all right, are we at risk of a bare market, given that the market tends to roll over before the recession happens. At this point, you can't argue the economy has slowed significantly. That's just simple fact. Whether ultimately the NBER comes back and says, okay, it was officially a recession, here's when it started, here's 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 bare markets X recessions is about 29%. With recessions, it's 32%. That's not a huge difference. The difference is more in duration. Recessionary bare markets have lasted longer, historically, about 60% longer. So I think the recession, no recession, may be more important in terms of how long does it take for us to get out of this sort of volatility cycle before we feel comfortable that, yes, we're indeed in a new upcycle, both in the economy and the market. So long answer, but I think it's important. It's a beautiful answer. Bridgewater is the largest hedge fund in the

world, and the CIOs from Bridgewater recently wrote that they are seeing the, quote, strongest near-term stagflationary signal in 100 years, end quote, and that could lead to, quote, instability and volatility over the coming decade, end quote. 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? So 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 and rising unemployment rate. So to the extent you're using a simple definition

of weaker growth, higher inflation is sort of a broad backdrop. Yeah, I think we're in that kind of environment right now. We don't have that unemployment component, though. And we may not have it to the same extreme or degree because I think there is still that low labor force participation. There's still that skills mismatch. There's still sort of labor shortages. And that I think is a big difference relative to the 1970s when there was such a demographic influx of workers. So I don't see a repeat of the 70s in terms of all the conditions that existed then that were embedded into that stagplation. What I think is happening that's maybe bigger picture and more important is, number one, I do think this is a more inflationary, secular environment that we're

in. And I think that will be borne out if we do, 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. So I think that may be the most important secular shift. And 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 cycles, economic cycles, more frequent recessions,

not necessarily deep brutal 0709 kind of recessions, but just more volatility in the economic cycle as labor rests some power back from capital. And you go in long cycles. You go in multi-decade cycles. And it just happens through a variety of forces. So there may be people who think I'm making some sort of political statement. 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. So that's more the way I think about the secular environment that we're heading into as opposed to just simply defining it as stagflation.

So 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? So diversification and rebalancing are always two of the most important disciplines, but I think the applicable nuances with both of them I think 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 the simple diversification that you were able to get with bonds as a sort of a counter to stocks, you're more limited in finding those opportunities if that negative yield price, 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. There may be maybe needs to be a greater consideration of inflation hedges or exposure to real assets. So I think, again, a broader lens in terms of diversification geographically too, not putting all your eggs just in the U.S.

basket. And I'd say that both on the fixed income side and on the equity side. And 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 kind of the democratization of other alternative asset classes. So we're not limited only to the stocks, bonds, cash allocation anymore. So I think investors should avail themselves of those diversification opportunities. And 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. And for many individuals, it might be done just on an annual basis.

And 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. So 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 of 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, sell high, because the

buy low, sell high almost suggests in and out. And I don't think get in or get out as an investing strategy. So 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. I love ending on that. Stay largely invested. So add low, trim high, use volatility as your friend. Lizanne, 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. I hope so too. It's always a pleasure. Thanks, John. 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 ourselves stocks based solely on what you hear.

I'm Chris Hill. Thanks for listening. We'll see you tomorrow.