Motley Fool Money - Liz Ann Sonders on Market Concentration and Economic Cycles

Episode Date: July 20, 2024

Liz Ann Sonders is a Managing Director and Chief Investment Strategist at Charles Schwab. The Motley Fool’s Bill Mann interviewed Sonders for our member event FoolFest. This show is a cut of that conversation. They discuss:  - How a deluge of economic information has changed investing.  - What’s happening beneath the surface of broad market indexes. - The Magnificent Seven and the best performers in the S&P 500.  Companies mentioned: SCHW, GE, NVDA Host: Bill Mann Guest: Liz Ann Sonders Producer: Ricky Mulvey Engineers: Desiree Jones, Kyle Carruthers Learn more about your ad choices. Visit megaphone.fm/adchoices

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But it also helps to explain to people who say, how can the market be so strong given, you know, fill in the blank? Inflation uncertainty, Fed Policy uncertainty, election uncertainty, two wars going on. And the answer is, well, under the surface, there's been a tremendous amount of turmoil and churn and rotation and weakness, may be more reflective of all these macro concerns. I'm Ricky Mulvey, and that's Lizanne Saunders, the chief investment strategist at Charles Schultz. The Motley Fool's Bill Mann caught up with Saunders for our member event, Fool Fest. And on today's show, we're playing a cut of their conversation. They discuss why individual investors don't necessarily need to be in the magnificent

seven to do well, the state of inflation, and how smaller companies could benefit from profit taking at the top of the market. So overwhelmingly, the people that you're speaking to individual investors, they have jobs, they have hobbies, they have kids, they have, you know, addictions to kids, they have Candy Crush, whatever it is that claims their time. As a professional investor, I've come to realize two things. One is that investing is pretty hard. And two, there's way more that I could focus on that I have time to focus on.

So I'm going to give you a platform for a moment. For individual investors, you know, with their Candy Crush Joneses and their taxable accounts, what do you think is the most appropriate way for them to incorporate the type of macroeconomic insights that you produce? Well, the absence of time for a lot of people means they just don't have the ability to drink from the fire hose of information that I do. And that's just because that's my job. It's not part of my job.

It is my job. It's not just interpreting all the information out there, but trying to weed through what matters, what doesn't matter, somehow get it to, you know, in my gut, in my brain, and then figure out a way to communicate that effectively to a very, very large, in our case, $9 trillion client audience. I think for most individual investors, there's a couple of important things to remember. First, have a plan. Before you start figuring out, well, what research should I consume on a day-to-day basis,

what should I be reading, what should I, who should I be following on social media, is actually have a plan. Have a plan driven by your own goals and your risk tolerance and your time horizon. and et cetera, et cetera, et cetera. You know, work with a professional. That's not, this is no longer the days of the private banking model where it was only the Uber wealthy that had access to help and guidance and advice and pretty much everybody does now. I don't manage my own money.

I don't, I'm not a deep dive expert on taxes or estate planning, any of that. And I have people that that work with. me to do that in my family. And don't worry about what you don't know. It's what we, it's not what I know or you know, Bill or any, you know, Yahoo on financial media or television is going to prognosticate about some bombastic prediction of what the market's going to do. That's not what matters. It's what we do along the way. And there's too much focus on this idea of get in, get out. And how do I consume the right information that's going to get me in at the right time, get me out at the right time. And I always say neither get in or get out is an investing strategy. All that is gambling on not just

one moment in time, but two moments in time. And nobody can do that. Well, you mentioned, you know, the Warren Buffett's and the Marty's Wigs. I don't know any successful investor that got there by all in, all out, get in, get out. But the nature of how we receive information, how much noise, how rapid fire everything is, the size and volume of the megaphones that some of the pontificators have, as if that's advice to the benefit of individual investors. And the complete opposite is actually true. It's amazing when you think about it. And you started by talking about going and looking at the microfiche

to learn about Marty Zweig and Zweig investing. To go back to the early 1990s, and if you were to be able to tell that Lizanne Saunders, what information was going to be available at your phone? fingertips now, you would probably say with 100% confidence that we all could make better decisions now. And I don't know if the opposite is true, but I do feel like we are drowning in information, and I don't know that it helps. I'm not sure it helps. I think I've honed the ability to at least at the base level understand.

what is valuable and what is total crap. I'm not sure that people who don't, it isn't their job to focus that on a day-to-day basis. And there is so much more information, but with that comes noise and bad information. And it has changed the landscape. It has shortened time horizons. That's one of the most detrimental things. And I think a lot of individual investors look at the speed of not just information, but of trading the access to that information with the click of a button at no cost, the ability to trade on that and looking at the lowercase HFT high frequency traders are doing and how much quant-based and algorithm-based and thinking that, well, we can play this game too by shortening time horizons and increasing activity and relying on all this

information out there. And it is, for the most part, detrimental to their long-term investment success. I always say as it relates to time horizons, which have gotten progressively shorter and shorter and shorter. If anything, all the cacophomy of noise should tell you to lengthen your time horizon because over any reasonable time horizon, fundamentals and prices do reconnect over any shorter term. There's no rhyme or reason to it at times. Yeah, that's certainly the case. I want to get into some specifics of a couple things that you've written. about recently, if that's okay.

And one in particular, there was a headline today, and we're recording this on the 10th, which is Wednesday, correct? Yeah. It basically said that the SMP 493, it's, it's time to shine. And you wrote very recently about the incredible and historic amount of concentration at the top end of the market and specifically the baffling statistic that only 15% of the S&P 500 companies have beaten their own index. Right.

At a time in which the markets, as measured by the S&P 500, are breaking records, that seems like on some levels pretty bad news. So, you know, another kind of headline or, or, you know, term I've been using to describe this market is a tale of two markets. There's what's been going on at the index level, and these cap weighted index is obviously driven by a relatively small handful of names. But that misses not just what's going on with some of those mega cap names, but what's going on with the rest of the market. And I think people focus on the market somewhat simplistically to their detriment at times, but also in a binary way. And you know, you started the comment and

question about the other 493 as if it's, you know, one or the other, Magnificent Seven or the 493. So here are some of the stats and the details that I think put all of this into maybe sharper focus. Yes, we have a top heavy market in terms of concentration, 10 largest stocks between 37 and 38% of the index. There was a time in the 1960s, I believe, where it was actually higher than that, but at least since the early 70s, that is a record. In and of itself, that isn't necessarily

some imminent sign of doom for the cap-weighted index. The problem arises when you've got such significant underperformance on the part of the rest of the market. We also have an interesting thing that's been happening over the past month or so, which it's like a version of the I forget, ODD, it's a disorder that affects children. It's kind of oppositional defiant disorder. I think I got that right. And there's been an attachment of that term to markets, because what's been happening in an acute sense in the past month or so is what the indexers are doing on a day-to-day basis,

the advanced decline, so the breadth, is doing the complete opposite. And it's not just when the indexers are going higher. Like on a day where the indexes do well to see a weaker AD, that's not. not terribly surprising, but the days where we've had weaker index performance, we've actually seen stronger participation. Here's another way to frame it. The S&P has had no more than a 5% drawdown this year at the index level. The average member has had a maximum drawdown of 16%. In the case of the NASDAQ, the NASDAQ at the index level has had only a 7% drawdown, maximum drawdown year to date. At the average member level, it is 40%, negative 40%.

Now, that tells you just how concentrated the market is, but it also helps to explain to people who say, how can the market be so strong given, you know, fill in the blank, inflation uncertainty, Fed policy uncertainty, election uncertainty, two wars going on. And the answer is, well, under the surface, there's been a tremendous amount of turmoil and churn and rotation and weakness, maybe more reflective of all these macro concerns. You just don't see it in the index, the index level because of capo. The last thing I'll say is there's too many people that conflate things like the Magnificent Seven or the biggest 10 to what the best performers are.

They're the biggest contributors to index gains because of the multiplier of their market cap. Of the Magnificent Seven, only one of them is in the top 10 best performers for the S&P 500. Two of the top 10 are utility stocks. One of them is going old school, which is GE. In the case of the NASDAQ, none of the Magnificent Seven are in the top 10. None are household names. I've been doing this for 38 years. I don't recognize a single company that is in the top 10 in the NASDAQ. So the point is for people to say you have to be in those names or you're a goner. Well, for professional money managers, for the fund complex that have benchmarks and the way they structure

their portfolios. But there's this misperception that individual investors can only be in those names and in size to do well. And that's just another example of understanding the real story as opposed to the headline story. I put it this way. I was having a conversation with some of our members earlier today. You may or may not agree with this. And if you don't, that's fine, you're smarter than I am. But I was like, look, if you have been primarily in small caps and you are barely trailing the S&P 500, you are probably killing it. Right. Yeah. And, you know, the other thing about small caps, I'm glad you brought up small caps. I think I would say this pretty much in any market environment, but particularly in this kind of market environment,

I think monolithic type investment decision making doesn't make a lot of sense, whether it's at the sector level or the style level or at the cap level. Increasingly, one of the more common questions I get is, what do you think of small caps? There's thousands of them. And one example of the importance of, we'll define the fundamentals or the characteristics is, as you know, we're very, very factor focus, thinking that you want to invest based on factors, which is just another word for characteristics. And if you just simply look at the factor of profitability and you apply it inside the Russell 2000, a simple application of let's group the stocks that are profitable and group the stocks that are not profitable. It's about an 18 percentage point difference

in the performance between those two cohorts over the past year. It's about negative 12% for the non-profitable, up 6% for the profitable. You can apply it at interest coverage. You can do it in terms of strong balance sheet, weak balance sheet. You can apply it within the S&P, not just in small cap. So I think there's still this, well, what sector is she like? Somebody said, well, tech. Well, there's a lot of horrible underperformers within the tech sector. There's a lot of great performers. There's a lot of great performers in the utility sector, like I already mentioned. So I think it's that factor-based analysis that at least needs to be additive to any work that people might traditionally do at the sector level or at the style level. The wild thing about what you just said is if you were to go back to 2021 during the height of the meme stock craze and the height of the SPAC influence, it almost would have been reversed.

Yes, absolutely. profitable companies were doing the best. That's right. And there are times where that happens. I think in 2021, if you wanted to point to a fundamental of why low quality worked, you could have pointed to the vaccines and the true reopening and an expectation that we were going to see the economy ramp, not just pull out of the malaise of the early part of the pandemic.

But then it fed on itself in terms of the whole phomo and spas. and memes and NFTs, and that just became its own, you know, tulip bubble kind of problem. But one thing, I'm glad you mentioned that because it didn't pop back into my head until just now. There's a lot of comparisons being made between now and not necessarily 2021. That was a short-lived speculative mania, but the late 1990s because of the dominance of AI as a theme, Internet, then momentum as a factor being the best performance.

factor, same thing in the late 1990s. But here's the difference specific to the momentum factor. And I always say momentum is defined as a factor, but it's more of a concept than it is a factor. It doesn't tell you all momentum means, if momentum is working, it just means that stocks that have been doing well continue to do well. It doesn't say anything about the fundamentals of what's doing well. Now, momentum as a factor was killing it in the late 90s. But the factor, fundamental factor, highly correlated to momentum was negative earnings. Now the fundamental factor most highly correlated to momentum, and there's several of them that have a high correlation or things like high return on equity, strong free cash flow, profitability. So yes, momentum is something that's working,

but it's momentum in stocks that are still maybe crazy expensive, but they have profits. They have strong. Great economics. Yeah. Right. So again, that doesn't mean they're not, you know, very, very richly valued, but that's an important differentiator relative to the late 90s. I love that. I want to try and put these two things together, which is in the past, when we have seen very high concentrations at the top end of the S&P 500, it has almost, it has almost been a one-to-one correlation that the way that those, that that that, that, that, that, concentration was alleviated was that the market went down and that the largest companies went down faster. But I do think that we're in a little bit of a different period of time. So with, so how do, how do small caps or smaller companies or the 493 or whatever catch up in a market that doesn't go down? Via rotation. And I think, you know, when I, when I cited the more extreme

statistic of the NASDAQ with the average member having had a 40% maximum drawdown, that breeds opportunity. In order for that opportunity to turn into better performance more broadly, it probably almost necessitates a pullback phase, a profit-taking phase, whatever you want to call it, up the cap spectrum in those mega-cap names. So my view is that if we start to see some of this concentration risk ease, it's probably going to come via convergence as opposed to the index is just solely catching down to the weaker underlying performance by the average member or the other 493 or the other 490, however you want to subset things. I think it could happen in both directions where you see this sort of grinding better participation down the cap spectrum, even within the large cap indexes like the S&P, while you go through this rotation and some profit taking. It's similar, though in a bare market phase, it's similar to what was happening in October of 2022.

And why at the time, we don't try to, I don't ever try to call tops and bottoms in markets. That's fools, Aaron. But our enthusiasm or our expression of, boy, this, the backdrop looks a little healthier. The internals look a little healthier. We were very vocal about that in October. We were not so vocal about that in June. So June of 2022, you had the first big sort of wish lower, pretty ugly performance. Interestingly, it was a time where sentiment was the ultimate K-shaped experience in sentiment.

Attitudinal measures of sentiment like AIAI, American Association of Individual Investors, in the lead-in to that big whoosh down in June, you went to a record high percentage of bears and a record low percentage of bulls, even exceeding COVID, the 2000 bust, the global financial crisis, even exceeding attitudinal measures of bearishness following the crash of 87. But AAI also tracks on a monthly basis the equity exposure of those same members that respond to the poll. And equity allocation was only about 1% off an all-time high. So ask them what they think. say, oh, I'm bearish. Had they done anything about it? Basically, no.

Were they hate investing? I'm sorry, go ahead. Fast forward to October, you had the puke phase where you had the washout on the attitudinal side. You had seen it on the behavioral side. But importantly, the indexes took out their June low and blew through them on the downside. But the breath under the surface had significantly improved. So it's the whole, and it's, you know, it's unfortunate. to have to use the war analogy or the battlefront analogy when you've got wars going on. But the whole notion of when you only have a few generals on the front line and the soldiers have fallen behind, that's not a very strong front. Even if some of the generals start to retreat,

but you've got more of the soldiers at the front line, that's a stronger front. And that's, in bare market style, that was what was happening in October 2022. So that's what I'll be looking for is a period where you start to see some convergence. And that might suggest there's more ripe opportunities to start to look for factor-based opportunities outside that small handful of megacabeneas. I do find it. It is probably at this point that the leaders do have, in fact,

a real economic power behind them, the fact that they are. I mean, given the valuations, they're speculative. But the businesses themselves, I think, are. beyond reproach. They are, but, but that, you know, the internet was a game changer, too. It's just, you had the lack of profitability problem, which doesn't exist now. Right. But no matter what, the underlying innovation or technology or something that's transformative, at some point, there usually is either sentiment-based sort of correction or valuation-based correction or some combination thereof because I think of sentiment.

I mean, I think evaluation actually is really a sentiment indicator or an indicator of sentiment. You know, we think evaluation is this fundamental thing because you've got the P, you've got the E. Those are things we can actually look at and see. But there are times when investors want to pay nothing from a P perspective on the overall market or individual stocks. And other times, you know, they're willing to pay nosebleed value. and that's where sentiment comes into the mix. There's that psychology thing again. You could almost call the PE the psychology to earnings ratio.

That's right. You're absolutely right. And that, by the way, that would be the most applicable degree probably doing what we all do. If you wanted to pick a degree that was most relevant to analyzing the stock market, it's a psych degree. Absolutely. I absolutely agree. Maybe my own liberal arts training, but I do want to try. I do love to put things into perspective.

And one of the big things that has happened over the last couple of years is that interest rates have gone up very quickly. And inflation is back. Now, I am, you know, I do know enough about finance to know that the reason why interest rates were so low was because the Fed and the powers that be were more worried about disinflation than anything else. or trying to bring about inflation. So from a contextual standpoint, if you analyze the rate of inflation going back since 2012, we're actually below historical averages. Is that the kind of thing that matters or is it just the fact that we are feeling it now so acutely? I think what matters and why so many people feel it so acutely,

why it's become part of the zeitgeist of what people think about and care about on a day-to-day basis in the application to things like responding to a consumer sentiment or a consumer confidence poll, just man-on-the-street kind of stuff, what plagues you right now, what you hear from small businesses in terms of what plagues them, it comes into the mix as it relates to politics, obviously, is that price levels are up so much. And I think the average consumer, the average individual thinks about inflation not in core PCE or core PCE services X housing, month-over-month readings and how that maps to year-over-year readings and the differential between CPI and PCE, they think, you know what, I'm still, I'm paying a lot more

for stuff than I was five years ago before the pandemic. It's as simple as that. And I think, I think in general, we're in a disinflationary period right now. I think we will ultimately see inflation get down closer to the Fed's target. But I also think we're in a secular environment of more inflation volatility. Probably most of your folks are familiar with the Great Moderation Era, at least that term that's applied. There are different start points depending on what characteristics you're looking at. But generally, it's the period from the mid to late 90s

until the early part of the pandemic. And it was a period marked by disinflation, almost the entire period of time, save for a bit of a pop in 2008, interest rates that were generally trending down the entire time, much less economic volatility, fewer recessions, generally a pretty tame geopolitical backdrop from an uncertainty perspective. And I just think most of those ships have sailed, globalization being such a force and China coming into the World Trading Organization in 2001 and basically providing the globe with cheap and abundant

access to goods and labor, everything that I just mentioned, those ships have sailed. So I believe we're still in a disinflationary moment right now, but I also think we're in a secular period of likely more inflation volatility. And I think the secular environment we're likely in, and we've been calling it the temperamental era, it's probably going to look a little more like the mid-60s to the mid-90s. And for the investors out there, which is your audience, obviously, the most important difference between the temperamental era from the mid-60s to the mid-90s and the great moderators. And the great moderation era is a relationship between bond yields and stock prices. During the temperamental

era, bond yields and stock prices were inversely correlated, almost the entire period of time. And that was because it was more of an inflation backdrop, more inflation volatility. So, fields were moving up sharply. It was often because inflation was picking up again, negative for the equity market. The great moderation period was a positive correlation between bond yields and stock prices, almost the entire period of time, because higher yields in that era meant stronger growth without the attendant concern about inflation, nirvana for the equity market. We're back in negative correlation territory, and I think that's generally where we're going to stay. It's not, doesn't mean investors don't have opportunity, but it is a different backdrop

than what a lot of investors got used to because it lasted 25 or so years. Lizanne, it's been a fascinating conversation with you and I really appreciate it. Thank you. My pleasure. I do want to finish with one thing. If you could give a piece of advice to the Liz Ann Saunders proxy who is working her way through university right now. What steps can she take to break into investment management? Well, first of all, I think there's never a better time in general for young people coming into this industry. And I'd maybe make it a little bit even additive for women who are looking to come into this industry because there's more wealth controlled by women now in the United States than there are by men.

and it is still an industry broadly financial services that is underrepresented by women. There's a big chunk of the financial services area, the wealth management, the registered investment advisors. That's basically a first generation business. And one of the big areas of focus for that segment of financial services is succession planning. I think there's never been a better time. Young people often say to me, I'd love to do what you do. but I could never do it because I'm not a math person.

I'm always very quick to say, neither am I. Never have been, never will be. It has very little to do with what I do. I think it's an awesome industry. So particularly if you're still in college, don't sweat the details, have a good time, learn how to balance, you know, work and play. That's probably the most important thing. And then the one most important piece of advice I give to young people when they start interviewing,

focus less on being interesting, focus more on being interested. Absolutely fantastic advice. Lizanne, thank you so much. My pleasure. Thank you. As always, people on the program may have interests in the stocks they talk about, and the Motley Fool may have formal recommendations for or against, so don't buy or sell anything based solely on what you hear.

I'm Ricky Mulvey. Thanks for listening. We'll be back tomorrow.