Beware one huge mistake investors often make when the economy is at a crossroads, says Charles Schwab’s investment chief

  • Charles Schwab chief investment strategist Liz Ann Sonders says we are moving into the third phase of the economy where growth decelerates but you still have accelerating inflation.
  • Sonders says “when it comes to the relationship between economic fundamentals and the stock market, better or worse matters more than good or bad. So understanding that it’s rate of change, it’s the market’s ability to sniff out an inflection point.”
  • She says historically economic data is almost always fantastic at the market top and terrible at the bottom.

Following is a transcript of the video.

Sara Silverstein: What’s the current state of the US economy and where is it headed?

Liz Ann Sonders:So we have had a view since we put out our 2018outlookthat we are late cycle and -but I think it requires a bit of a qualifier. I think it’s later in time terms, maybe not so late in temperature termsor – you know, later in calendar but not character. Whatever, you know, fun way you want to describe it.

That said, I think we are now starting to see even some of the character of the economic cycle suggests that we are late, not just a function of how long this one has gone on. I think we are, maybe not yet in, but moving into, the third out of four phases of the economy.

When you first come out of a recession you have accelerating growth but still decelerating inflation and that allows monetary policy to stay really loose and then you move into the phase where both growth and inflation are accelerating, but the Fed tends to be earlier in their cycle, so it doesn’t choke off the recovery.

I think we have to be mindful of a move into the third phase which is when growth decelerates but you still have accelerating inflation,and it puts the Fed in a little bit of a trickier spot because they may have to continue to tighten into the inflation problem potentially, all the while growth is slowing. And that tends to cause a shift in market behaviour too,where you start to see more defensives lead and a little bit more of a value focus by investors. SoI just think we should be on the lookout for that possible transition.

Silverstein:And what do you think for themarket lookout? Where are stock valuations and how much of it has to do with the economy?

Sonders:Overall, valuations are not excessive. Some of the longer term measures, things like the Buffett model, market cap to GNP, certainly things like Shiller’s CAPE. Iquestion the value of that as a short term market indicator, but I think it tells you that long-term returns are unlikely to match what they have been, say in this cycle so far.

But we’re not in an environment that allows for valuation expansion. In fact, much has been said about the huge surge in earningsthatwe’ve seen this year, which is probably not over, but valuations have actually compressed this year and it’s not just because the market hasn’t rallied as much as profits have increased. I just think the overall background conditions are not supportive of an environment of valuation expansion, which in turn means you need to continue to see decent earnings growth to support the market,because you’re not going to get it by the background that suggests valuation expansion can happen on its own. And earnings still look great.

I think we have to be mindful of a peak in the earnings growth rate, not a peak in earnings but a peak in earnings growth rate,and a worry that maybe the expectations bar has gotten set a little bit too high and/or extrapolated too far into the future.

Silverstein:And what isthe relationship between economic growth and the stock market?

Sonders:This – I must say, this represents, in my mind, one of the biggest mistakes that investors often make at inflection points in both the economy and the market. So we’re all taught about the market as a leading indicator and it tends to move in advance of big shifts in the economy. Bear markets tend to occur in conjunction with recession but they tend to start before recession.

By nature of the fact that the market is a discounting mechanism, almost always at a market top, the economic data is fantastic. Which is whyI -one of my kind of catchphrases for years, decades, has been: when it comes to the relationship between economic fundamentals and the stock market, better or worse matters more than good or bad. So understanding that it’s rate of change, it’s the market’s ability to sniff out an inflection point.

An inflection point from really great growth to weakening growth, by definition, is the top of the V and when you’re there, the data looks fantastic. Same exact thing happens at market bottoms. March of ’09, look at the economic data, it was absolutely atrocious, but we know in hindsight that the market was saying, “Yes, it’s atrocious, but from here it gets better.”

And I think too often investors focus on the level of economic data without understanding that it’s rate of change, when you start to see a rolling over, keeping an eye on the leading indicators and what they’re telling you, and that’s what I think investors miss, isthey say, “Well, how could we possibly have trouble in the market? GDP is strong, unemployment rate is low, retail sales are strong.” But look at any major market top and look at the economic data and it’s always great.

Charles Schwab ChartCharles SchwabEconomic data is almost always fantastic at the market top.

Silverstein:And we’re – and youthink that we might be at in an inflection point for economic growth and for earnings?

Sonders:Some measures of economic growth, I think we could be at an inflection point and some of it is a function of what’s happening in the world of trade. So we had been in a healthy acceleration in thecapex cycle,in part due to just the length and strength of the economy, there was a need basis for it, given that our stuff is really, really old, and then we got the kicker from tax reform on both the corporate side and the consumer side. Sothat set in sort of the next elevation in thecapex cycle,but unfortunately, some of the leading indicators of that, survey based but also hard data based, suggest that there is a little bit of a pause happening right now, notacross the board, but by many companies who say, “We’re just going to wait and see what unfolds here in the trade and tariff situation before we continue to commit to theselong-termcapital investments.”

So I think that’s a component of it that is not just based on where we are in the cycle, but this added wrinkle of what’s going on with trade.

Housing is another one. We’ve started to see some faltering in housing and although it only represents about 5% and change of GDP, the ripple effects into the economy are important. I think we have to be mindful of that.

We’ve seen this huge surge in consumer confidence. That’s great but consumer confidence peaks -and I don’t know that this is a peak -tend to correspond with stock market peaks too. So this is not run for the hills. I’ve not moved from being bullish on the market to bearish on the market, I just think we have to be extremely cognisant of where we are in the cycle and have kind of a checklist of things to look out for.

Silverstein:And so what are you telling investors? What should investors be doing?

Sonders:So from a tactical perspective,we -late last year we did, what I would call, neutralise our equity recommendations. So we make broad recommendations for our clients that would like to hear our tactical views in the context of a strategic portfolio, a long-term portfolio. What neutralising equity exposure means the three asset classes – equity asset classes on which we have a recommendation- areUS equities, developed international equities, and emerging markets equities.And we neutralized those, basically all three at neutral, which is not a bearish position, but just tells investors don’t take undue risk beyond what your normal allocation would be to those asset classes.

And then more recently, just a couple of weeks ago, we effectively did the same thing within theUS equityallocation. Weneutralized the sector recommendations, where we had had three outperformed ratings, three underperformed ratings. We kind of wiped two of those out by moving to neutral. In the case of the outperform, it had been health care, technology,and financials. We moved financials andtechnologydown to neutral and we just have healthcare as an outperform.

So that was reflecting a need to not take undue risk at this point in the cycle. Without that overall de-risking that we would do by lowering overall equity allocation or doing it more defensively in the sector recommendations.

Silverstein:And what do you like about healthcare and what’s the concern about tech?

Sonders:The concern about tech was – had very little to do with sort of company fundamentals and more to do with valuation and momentum characteristics and a little bit of a concern that given some bit of narrowness in where the leadership was, thatwe just wanted to reflect that in the sector recommendations. Andwe’ve had a long and very successful outperform rating on technology,so just felt that the idea toward rebalancing can be reinforced by recommendationsthatwe might make at the sector level and that’s the other thing that we’ve been telling our investors, that you can talk about the short-term tactical shifts all you want but ultimately, there’s no free lunch in this business. And the key factors that anybody should focus on, regardless of environment, are the tried and true disciplines aroundthingslike, have a plan, be diversified, rebalance around it. It’s kind of a boring thing to talk about if you’re doing a three-minutehit in financial media, they don’t want you to talk about rebalancing. The beauty of rebalancing is it forces you to do what we know we’re supposed to do and we’ve been taught to do, which is buy low, sell high. When left to our own devices, we tend to do the complete opposite. And it means you don’t have to worry about which pundit going to have the right market call, whether it’s yourself or somebody else you’re listening to or reading. Your portfolio tells you when it’s time to do something. So it was more about reinforcing: don’t let your winners just run to a much, much higher weight in your portfolio because at the point it shifts, and it will and we will hit an inflection point, you don’t want to be kind of left holding a bigger bag.

Silverstein:And what’s good about healthcare right now?

Sonders:So we actually moved our rating to outperform in healthcare during the initial uncertainty in the current administration with regard to the Affordable Care Act and felt that the sector was the ultimate baby thrown out with the bathwater. There was just so much uncertainty that I think analysts and investors stopped doingcompany-to-company, industry-to-industrywork within that sector. So to some degree, it became a bit of a value story at the point we raised it from neutral to outperform. Right now, we think it represents a number of interesting factors. It represents a bit of defence and we started to see, over several periods this summer that shift away from those,you know, highgrowth leaders toward more defensive. You saw utilities kind of pick up in outperformance. You saw it in real estate investment trusts. And health care just represents, it represents a bit of a value play but it still has a growth story, it’s got a restructuring story broadly, and it’s got that kind of defence without just hugging the bond proxies, which are also not likely to provide the kind of upside.

Silverstein:And what’s the single biggest risk, do you think, to the market that could force a correction faster than expected?

Sonders:I think if – to the extent you don’t believe we’re already in a trade war – which I think it’s hard to argue we’re in a full on trade war – and we’re seeing appropriate steps being taken within NAFTA with Mexico and Canada and theEU,but clearly things are still quite tense with regard to China. I think if we were to continue to head down a slippery slope toward a trade war, I think that represents- of the things we know right now, i.e.,there’s always the exogenous shock, black swan, I think that’s a big risk. Kind of second to that, we’re seeing some fractures within the emerging markets. We’ve seen it in Turkey, more recently Italy. I do think that this environment is somewhat reminiscent of the late 1990s. I don’t think we imminently have along-termcapital management type blow up but to the extent that this starts to fester, what’s been concentrated in just a couple of countries and becomes a broader crisis, I think that will infect all high risk markets as well. So those would be the two things in the near term that I think could sort of rock the ship a little bit.

Business Insider Emails & Alerts

Site highlights each day to your inbox.

Follow Business Insider Australia on Facebook, Twitter, LinkedIn, and Instagram.