Stock Watch

Listen to Your Portfolio

Tune out market prognosticators and let your asset allocation help guide your investing decisions, says Liz Ann Sonders, Charles Schwab's chief investment strategist.

By Manuel Schiffres, Executive Editor, Kiplinger's Personal Finance

November 3, 2009

Liz Ann Sonders, Charles Schwab’s highly visible chief investment strategist, differs from most Wall Street gurus in two basic ways: She considers herself first and foremost an interpreter of market events, rather than a forecaster. And unlike most prognosticators, who direct their bombast at big, institutional clients, Sonders focuses her missives on individual investors.

With the stock market looking wobbly of late and many investors worried that the big bad bear’s hibernation may be short-lived, we thought it would be a good time to get Sonders’s take about recent market and economic developments. Sonders says she is generally optimistic about the market’s prospects but adds that investors shouldn’t base their moves on either her words or those of sundry market prophets. Instead, she says, you’ll profit more by listening to your portfolio.

KIPLINGER’S: The stock market seems to have run into a wall the past couple of weeks and, as the month of November is getting under way, is down about 5% from its high. Is this just a matter of investors catching their breaths, or has the fundamental outlook suddenly turned more negative?

SONDERS: The honest answer is, I don’t know; nor does anybody else. A correction of that size in the midst of a very strong uptrend is absolutely normal. We don’t know what this will ultimately lead to. But I don’t think the market is sending signals that we are on a path to retesting last March’s lows.

The two corrections that preceded the current one during this bull run have been corrections more in time and less in price -- that is, an extended period of consolidation during which the decline was not that large from peak to trough. We were overdue for a correction that was a little bit sharper in percentage terms and possibly over a more condensed period of time. So this would be sort of the mirror image of the two mini corrections that we saw prior to this one.

The government’s preliminary report on gross domestic product shows that the economy grew 3.5% in the third quarter. Does that suggest that the economy is out of the woods?

I think the recession actually ended in the second quarter. So, to see a relatively strong third quarter is not a surprise to me. What we’re starting to see is the effect of what I have been calling coiled springs. There was such a compression in the fall of 2008 in every metric for the economy -- whether it was consumption or business investment or inventories and so on -- that I think we’re in the beginning phases of the natural snap-back from that.

The inability of consumers to ramp up, which in the past they’ve been able to do, is probably what kept the third-quarter GDP from being even stronger, because historically the first quarter coming out of a recession, particularly if it was as deep recession as this one, has been much stronger than the 3.5% growth we saw. There are very obvious reasons -- pressures on the consumer, debt, deleveraging -- that have conspired to keep a lid on GDP growth. That said, it was certainly better than expected. So, the report, for the most part, was good news.

On the other hand, there is some feeling that growth in the third quarter was propped up by one-time events.

There are legitimate concerns that monetary policy is a bit one-time in nature and that the economy will roll over again once the Federal Reserve pulls back the juice that the increased liquidity has provided. And then there’s the fiscal side of the stimulus measures -- “cash for clunkers” and the tax credit for first-time homeowners being good examples of that. We don’t know at this point whether the tax credit will be extended. We know that the impact of “cash for clunkers” was certainly front-end-loaded and that we’re seeing a pause in the demand that “cash for clunkers” brought out.

What we don’t know is whether third-quarter growth was just a temporary blip or whether at some point we’re going to move into a more self-sustaining phase of the recovery. I’m marginally more optimistic than the consensus that we can get ourselves to that point, but I think the path between now and then will be choppy and fraught with volatility.

You’re not in the camp that worries about the possibility of a double-dip recession?

The more likely scenario is a square-root economy, not a double-dip, whereby we get the V-shaped recovery initially, followed by a flattening out of economic growth.

For stock-market investors, how do you weigh the current opportunities versus the potential risks?

As we now know in hindsight, the opportunities were quite phenomenal back in March, and I don’t think it’s going out on a limb to say they’re less enticing now. That said, I don’t think we’re without opportunities. We’ve come through the first phase of a new bull market -- whether it’s just a cyclical bull market in a secular [long-term] bear market or the start of a new secular bull market (these issues involving semantics are often silly because you may miss out on some great opportunities while you’re trying to define the nature of the market).

So regardless how we ultimately label the market, it’s very natural to have seen what we saw, which is a market that was biased toward very, very low-quality companies. That is actually fairly normal. What we’re likely to see now is a shift into an environment in which fundamentals will come a little more into play and where quality will be rewarded to a greater degree. So I think high-quality companies have a better shot at being winners in the next leg of the cycle.

So should investors who have substantial profits in low-quality companies take some profits there and put the proceeds in blue-chip stocks?

The short answer is yes. The long answer relates to a process and a philosophy that investors should practice perpetually but that they rarely do. There’s this misperception that there are only two basic approaches to investing: You can be a short-term trader or you can be a long-term, buy-and-hold investor. But I think most people have an incorrect perception of what it means to be a buy-and-hold investor. They think it means to establish a portfolio, with the appropriate asset allocation, then let it run, hoping that the long term accrues to their benefit.

But there’s a discipline that should be associated with long-term strategic asset allocation, particularly when markets are volatile. That discipline involves letting your portfolio tell you when it’s time to do something. If your low-quality stocks -- your D- and F-rated stocks, to use Schwab parlance -- are now a more dominant position in your portfolio, or your emerging-markets equities are a bigger percentage of your portfolio than they were when you first established your asset allocation, then your portfolio is telling you that you should be reigning in your exposure in those areas. And the same goes for asset classes or individual positions that have become underrepresented in your portfolio.

Sounds like rebalancing.

Basically, yes. It is the voice of your portfolio telling you when to do something. Approaching it that way forces you to do what we know we’re supposed to, which is to sell into strength and buy into weakness. When left to your own emotional devices you often end up doing the opposite of what you’re supposed to do.

Let’s talk about some potential risks to the stock market. Rising inflation?

Not a near-term risk at all in my opinion. Inflation nearly always is triggered by upward wage and unit-labor cost pressures, none of which are present. It is always typically accompanied by tight capacity utilization, also not present. Finally, although the financial system has been pumped with liquidity, the “velocity” of money (or the “money multiplier”) remains incredibly weak. In other words, the liquidity is not getting out into the economy -- an inherently deflationary circumstance.

Rising interest rates?

I think the Federal Reserve is going to have to start raising rates sooner than a lot of people think, particularly if it opts to rein in asset-price inflation.

Within a year?

It depends on the circumstances. I know everybody loves to try to put dates on it, but it’s going to depend on inflation expectations and what happens to the aforementioned wages, unit labor costs, capacity and the velocity of money. Those are the traditional triggers for the Fed. The first thing we’ll likely see is a change in the language in the statements accompanying rate decisions that come out of Federal Open Market Committee meetings.

A lot has been said lately about the weakness of the dollar -- is that a risk for the stock market?

One can argue just the opposite -- that any strength in the dollar will be a risk to the market -- because that’s exactly what’s been happening lately, at least on a day-to-day basis. The rally in stocks that started in March has been directly accompanied by a dollar weakness.

There are a number of reasons for that: Number one, a weaker dollar feeds into stronger exports and, with a much greater percentage of U.S. companies getting revenues from overseas, that’s accrued to the benefit of corporate profits.

On the other hand, what I think is the real driver behind the weakness in the dollar and the strength in the market is just animal spirits and the reversal of the risk trade. Late last year and early this year investors wanted to be nowhere other than in short-term Treasuries, resulting in a safe-haven flight to the dollar.

Now we are seeing a re-emergence of animal spirits and a flight away from the dollar. In addition, with U.S. interest rates so low, the dollar has become the funding currency for what is called the carry trade. Investors borrow in very cheap dollars and then sell those dollars to buy asset classes with potentially higher returns. There’s a lot of money chasing performance presently, and categories being chased include U.S. stocks, gold, oil, emerging-markets equities, commodity-based currencies, and so on. This is just the risk trade at work. That’s why the dollar has been down as stocks have rallied.

Should investors worry about the possibility that Congress will let the Bush tax cuts on dividends and capital gains expire at the end of 2010?

I think they absolutely will. But it’s not just about the Bush tax cuts. It’s tax policy in general, on both the personal side and on the corporate side. And one of the reasons we’ve seen things like the strength in gold and weakness in the dollar is pure uncertainty, and tax policy is just one of many things about which we have great uncertainty. So, yes, investors should be concerned about the possibility of taxes going up across the board.

What does the run-up in gold prices tell you?

It tells me that it’s an asset class with a lot of momentum behind it. There’s a lot of money chasing whatever has done well. A misperception about gold is that it has big rallies only when there’s either a concern about inflation or inflation is actually rising. But, if you look back in history, you’ll see that gold has rallied as often in deflationary environments as it has in inflationary environments. About the only consistent factor during big gold rallies is uncertainly.

A year from now, where do you think the stock market indexes will be relative to where they are today?

They’ll probably be higher, but it’s very unlikely that the path on the way to higher looks like it has the last seven months.

Well, that would be pretty miraculous.

It would be lovely to go along for that ride, but there would also be a peril to that. Unquestionably, when you have that strong a rally over that extended a period of time, the extreme optimism that accompanies it suggests that we increase the risk of larger corrections. I expect a choppy path, but that may be the better path.

Are there sectors or investing styles that look more attractive now than others?

For the bulk of this rally, our sector ratings, which are made with a six- to nine-month time horizon, have had a very cyclical bias, with “outperform” ratings on technology, materials and industrials. I wouldn’t yet say that that stance is getting long in the tooth, but at some point we will probably bias our outperform ratings a little bit away from those early-cyclical plays. Our “underperform” ratings currently are on the more classically defensive sectors -- consumer staples, utilities and telecommunications, with the latter driven by valuation concerns, not the sector’s defensive characteristics. But there’s no question that in the course of the next year those ratings will change, probably multiple times.

To get a sense of where the stock market is going, what data and events should investors be focusing on?

Although I don’t think inflation is much of a short-term risk, it is an extremely important factor for the stock market, for a whole host of reasons. One: Rising inflation changes the interest-rate story, which, in turn, makes fixed-income investments more competitive with the stock market.

Valuations are also directly tied to inflation in an inverse way. Over history, there’s a perfect inverse correlation between the level of inflation and the market’s price-earnings ratio. Historically, the lower the inflation rate, the higher the P/E and vice versa. For the same reason that a dollar we earn from Kiplinger’s or from Schwab is more valuable to us in a low-inflation environment, corporate earnings are more valuable to investors in a low-inflation environment and less valuable in a high-inflation environment. So inflation is certainly something to keep an eye on.

We need to also keep a close watch on valuations, particularly the denominator part of the P/E ratio. We’re clearly coming into the sweet spot for earnings. With earnings highly depressed in the past year and with corporations having wrung out tremendous amounts of costs -- compensation and otherwise -- the comparisons are getting easier. But that’s not going to continue in perpetuity.

We’ve been hearing a lot of the phrase “new normal,” referring to expectations of a period of subpar economic growth in the United States for years to come. Do you subscribe to that idea?

For the most part, yes. But let me give you a caveat. If that view is wrong, it may be because we see a significant impact on our economy of strong growth outside of the U.S. People may be underestimating the impact of non-U.S. consumers -- particularly consumers in emerging nations -- on the U.S. economy as it strives to become more export-oriented, a process that a weak dollar helps.

This is not to suggest that emerging-markets consumers are going to cause our economy to fly. But this is an idea that intrigues me. Just looking at consumers from the BRICs -- Brazil, Russia, India and China. If you add up their consumption and add up U.S. consumption, then divide the former into the latter, that ratio has tripled in the past seven or eight years. So we’re seeing very, very fast growth in the number of these consumers and their propensity to spend. The key is for us to take advantage of that trend and not muck it up with protectionist policies -- understanding that in a global economy, we have to keep our doors open.

I suppose you can add protectionism to the list of risks.

Last question: Much has been made of the fact that over the past ten years, bonds have handily outperformed stocks. Should investors continue to base their decisions on the idea of stocks outperforming bonds over the long, long term?

Not only have bonds outperformed stocks over the past ten years, they’ve done so over the past 20 to 30 years, too.

Nothing like two horrendous bear markets to stack the deck against stocks.

After a ten-, 20-, 30-year stretch in which bonds have outperformed stocks, the cynic in me can’t help but ask, “Now you’re going to bias your asset allocation dramatically toward fixed-income because bonds have outperformed stocks?” I’m often skeptical about supposed major paradigm shifts, particularly as it relates to how people are investing their money based on performance that has already happened.

We had a record-breaking bull market in bonds starting in the early 1980s and two horrific bear markets for stocks, both of which conspired to overturn the stock market’s traditional long-term performance advantage over bonds. I’d be very careful about dramatically shifting your emphasis to fixed-income purely based on historical performance.

That said, as the baby-boomers get older and they go into retirement, they will have a greater need to protect and preserve what they have. That provides a natural demand for fixed-income investments. That demand will come for the natural and correct reasons.

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