Investors, Ride Out This Market's Waves
Liz Ann Sonders, the chief investment strategist at Charles Schwab, has earned a reputation for her spot-on analysis of the stock market and the economy and a knack for connecting with individual investors. Sonders, who graced the cover of our January 2010 issue, is impatient with perma-bears who pooh-pooh the economic recovery and says the volatility in stocks is not the onset of another bear market. Still, she says, the correction is not over. So far, the Dow Jones industrial average is down 10% from its April 26 peak. As Sonders met with Kiplinger editors late afternoon on May 25, the Dow managed to reverse nearly all of a 292-point loss and closed at 10,043.75, down just 0.23% for the day. Following is an edited transcript of our conversation:
What are we to make of this market?
I’m not a market-timer, so I’m not telling clients to back up the truck and load up. But to me, this smacks of an ultimate buying opportunity. I think we can have an up year, but there could be a decent amount of pain between now and then. If you look at the historical cycles, at about the 14-month point of bull markets you get something more meaningful than a 10% correction, something more along the lines of 15% to 20% -- and that’s just about how old this bull market is.
I expected that this would be a choppier year. But what I find especially troubling is the mechanics of the market. What’s nerve-wracking about what we saw in the "flash crash" on May 6 and the explosive rally later is all of this machine-to-machine trading -- a lot of funky things happening that go far beyond what the fundamentals would suggest. I’m surprised more has not been done by regulators in terms of curbs and circuit breakers. Unfortunately, I think the machines are going to cause more mini-dramas.
What will it take to stop the bleeding?
I ultimately think it’s investor sentiment that turns things. I look at a variety of sentiment measures, and it’s a mixed bag. Certainly the frothiness that existed at the April highs has been taken down a peg. One of my favorite indicators is the Smart Money-Dumb Money Confidence Index from SentimenTrader.com ($25 a month or $250 a year, free trial available), which looks at the trading of institutional investors -- the smart money -- compared with the trading of small investors -- the dumb money. Recently, the smart money had a higher optimism level than the dumb money, which is a positive sign.
Speaking of optimism, where do you stand on gold?
When an exchange-traded fund is the fifth-largest holder of gold, owning more gold than most countries, that tells me that there’s a lot more performance-chasing demand than there are fundamental underpinnings for gold at current prices. Does that prevent it from going higher? No. We don’t cover gold officially as an asset class, but people are perpetually interested in how much exposure they should have to gold and other alternative investments. Our general rule of thumb is 5% of your portfolio, and be very mindful about rebalancing on a regular basis.
What do you like in the stock market now?
That depends on the kind of investor you are. I ultimately think that this will prove to be a decent buying opportunity, but that doesn’t mean every investor should go out and buy. The sectors we think will do better than the market are health care and technology.
A lot of people think we’ll repeat the pain of 2007-2009. I wouldn’t bet on that. There are substantial differences between then and now. We were on an economic downswing then; now, there is very clear stability. We’re moving as we speak from economic recovery to expansion mode. Manufacturing is in a V-shaped recovery, inventory replenishment is V-shaped, and global industrial production is in the most dramatic V you’ve ever seen. We’re in a soft patch right now, but I still don’t think a double dip is the likely path.
Doesn’t slower growth in Europe suggest slower growth in the U.S.?
We have seen a slowdown on the exports side. Twelve percent of gross domestic product is exports, and 12% to 18% of that is to Europe. But there are offsets. Asia is booming. China is engineering a soft landing right now, and other areas, such as Singapore and Taiwan, are booming. I don’t view a slowdown in Europe as a disaster. And not all of Europe will double dip; Germany and France are likely to stay in positive territory.
Are interest rates a concern?
Before the implosion in Europe, I’d been thinking that the Federal Reserve might start thinking about raising short-term rates. I thought we’d see something this year. Now I think that’s been tabled by what’s been happening in Europe. Long-term -- very long-term, as in the next five to ten years -- the outlook is fairly negative for fixed-income investors, as rates rise and bond prices fall. But in the short run, there’s probably going to be a rally in bonds. Anytime you get a four-percentage-point spread between very short-term rates and the rate on ten-year Treasuries, you see a pullback in long-term yields. But I’m surprised to see the ten-year yield below 3.1%. The pendulum may have swung a little too far, unless we’re about to enter into severe deflation. That’s a real concern.
What are your deflation fears?
I’ve felt all along that deflation was a bigger worry than hyper-inflation. Most financial crises that are debt crises end up being significant deflation events. Yes, we pumped a tremendous amount of money into the financial system, but it’s not changing hands and circulating through the economy -- unless that picks up, it’s almost impossible to get inflation. Nor do I see any increases in labor costs, wages or pricing power. Deflation -- not low inflation or steady-state disinflation, but a true downward spiral -- that’s more toxic for financial markets than inflation is. We’ve been in the sweet spot, but the risk is that we’ll move out of it on the downside.
How do the massive deficits figure in your forecasts?
To me, the silver lining to the disaster that is Europe right now is the message that I hope it sends: Profligacy has a limit; government spending has a limit. Already there is more public awareness and scrutiny of the perils of debt. In the past when we’ve had high levels of debt to gross domestic products or big deficits, the public hasn’t cared, they haven’t voted on it. Now it’s a top-of-mind issue for voters. We may have hit the wall in terms of debt and deficits. We’ve crossed 90% in terms of federal debt as a percentage of GDP. That’s the threshold above which you’re really limited in how much you can grow the economy. That’s why I think the ultimate shape of the recovery will be a square root, with an initial V-shaped rebound that levels off.