Listen to Your Portfolio

Liz Ann Sonders, Charles Schwab’s 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 addresses her missives to individual investors.

With many investors worried that stocks have come too far too fast since last March, we felt this would be a good time to get Sonders’s take on recent market and economic developments. Sonders says that 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 port-folio. What follows is a condensed version of an interview that was posted at Kiplinger.com in early November.

KIPLINGER’S: Is the U.S. economy out of the woods yet?

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SONDERS: I think the recession actually ended in the second quarter. So I was not surprised to see a relatively strong third quarter. We’re starting to see 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 that we’re now in the beginning phases of the natural snapback from that.

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

The more likely scenario is a square-root economy, whereby we get a V-shaped recovery initially, followed by a flattening out of economic growth.

How do you weigh the current opportunities in the stock market versus the potential risks?

As we now know in hindsight, the opportunities were phenomenal back in March, and it’s not going out on a limb to say they’re less enticing now. That said, I don’t think we’re without opportunities. In the first phase of this bull market, we saw a market that was biased toward very, very low-quality companies. 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 the market will reward quality to a greater degree in the next leg of the cycle.

So should investors take profits in low-quality stocks and put the proceeds into blue chips?

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 a discipline that should be associated with long-term strategic asset allocation, particularly when markets are volatile. If your low-quality stocks 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 reining in your exposure in those areas. And the opposite goes for asset classes or individual positions that have become underrepresented in your portfolio.

Let’s talk about some potential risks to this new bull market. Rising inflation?

Not a near-term risk at all in my opinion.

Rising interest rates?

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. The first thing we’ll likely see is a change in the language in the statements that come out of Federal Open Market Committee meetings.

Is a weak dollar a risk for stock investors?

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 this, among them that a weaker dollar feeds into stronger exports. What I think is the real driver behind the weakness in the dollar is just the reversal of the risk trade. In late 2008 and early 2009, 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 reemergence of animal spirits and a flight away from the dollar.

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?

Yes. But they shouldn’t worry 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.

A year from now, where will the stock-market indexes 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 will look like it has the past seven months. 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.

What sectors look attractive now?

For the bulk of this rally, our sector ratings, which are made with a six- to nine-month time horizon, have had a 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 and toward more classically defensive sectors.

We’ve been hearing a lot about the “new normal,” referring to expectations of a period of subpar economic growth in the U.S. for years to come. Do you buy into 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. The key is for us to take advantage of that trend and not muck it up with protectionist policies.

Bonds have beaten stocks over the past ten and even 20 years. Should investors continue to base their decisions on the idea of stocks winning over the long term?

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 they relate to how people invest their money based on performance that has already happened. That said, as the baby-boomers get older and retire, 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.