The stock market volatility earlier this month caught a lot of investors off guard, reminding us about those brokerage and retirement plan statements that many of us file away without looking at. Reacting to a market movement is generally a bad idea. The instinct when the markets drop is to sell (often selling low). During recessions, if you wait for the headlines that stocks are in trouble, it’s too late to protect yourself.
So what is a better strategy? For solutions about designing a healthy nest egg, and what was behind the market volatility October 10th and 11th, I turned to Liz Ann Sonders, the chief investment strategist and SVP at Charles Schwab.
Natalie Pace: What happened to spark the 5% sell-off in stocks October 10-11, 2018?
Liz Ann Sonders: Sentiment got way too frothy. The increase in investor sentiment—back toward levels of optimism last seen in advance of the February correction—suggested investors had become too complacent about the risks to the stock market.
NP: Are you worried about U.S. stocks right now?
LAS: We’re still in a secular bull market, but we have to be mindful of some cyclical hiccups. We are currently overweight on U.S. large caps, and underweight on U.S. small caps. We are neutral on developed international and emerging markets.
NP: What are the risks to the stock market?
LAS: We’ve gotten no indication yet that the risk of a recession is high… The one thing that might shorten the runway between now and the next recession would be if the trade tensions between the U.S. and China significantly ramp up.
NP: Some very high profile people, including Alan Greenspan and Warren Buffett, have gone on record saying that stocks and bonds are in a bubble, or, at minimum, very expensive.
LAS: We don’t have any major single asset bubble. However, we have a number of micro bubbles. One of those micro bubbles was the short volatility trade – with one in particular called the XIV, aptly initialed as the inverse of the VIX. When volatility got low, this vehicle made more and more money. In February, that micro bubble exploded. A lot of investors who were caught on the wrong side of that had to scramble and they had to sell other things to access the liquidity needed to cover that position.
NP: Are stocks too expensive?
LAS: Traditional P/E ratios, whether they are on forward earnings or trailing earnings, are not that rich. The forward P/E on the S&P500 is 16.8 and the long-term median is 16. However, because of the surge to earnings this year, due to the tax cuts in particular, the fear is that investors and analysts are extrapolating strong earnings too far into the future. When we get to the first quarter of 2019, we’re comparing it to the first quarter of 2018, which was the first quarter from a tax cut perspective. You don’t keep repeating those year-over-year gains, when you have that initial push from tax cuts.
NP: What should the Main Street investor be doing right now?
LAS: Household exposure to equities is at the high end of its historical range because there has been very little rebalancing. You can do some hedging, or you can just do the tried and true rebalancing, dollar cost averaging and diversification. Rebalancing forces you as an investor to do what you know you are supposed to – which is buy low, sell high, or add low, trim high. And it means that your portfolio is going to tell you when it is time to do something. You don’t need to worry about which yahoo on the financial networks has the right bombastic call.
NP: Will Stocks Be Hurt By Rising Interest Rates?
LAS: Industries and sectors are rate sensitive, with housing being key. When we’ve seen housing roll over in the past, it has been a warning sign. Rising interest rates affect highly leveraged companies that have to pay down debt. You can find those across the spectrum, including financials. We have taken financials from an outperform down to a neutral. The reason why the inverted yield curve has almost always brought on a recession is the crush that causes for the financial sector, and the implications that has more broadly. Spikes in oil prices have also preceded recessions pretty consistently. $80/barrel can’t be classified as that, but it is something we need to watch.
NP: The yield curve is almost flat – pretty close to that inversion point…
LAS: We’re definitely getting a hike in December. This is assuming they stay on an every-other-meeting schedule. However, an inversion of the yield curve is further down the road.
NP: What’s your take on tariffs?
LAS: Trade Wars almost always raise inflation and lower growth. A big part of the success of our economy for the past couple of years has been because of animal spirits. The soft economic data, the survey data and the confidence data, has been stratospheric, even though the hard economic data has not been as robust. If this trade war starts to dim animal spirits, what is the cost of that across the economic and market spectrum?
If you’d like to access more of Liz Ann Sonders wisdom, she and her team publish publicly-available market commentary at Schwab.com. Last month, I published bond tips from Liz Ann Sonders’ colleague Kathy A. Jones, the chief fixed income strategist at Charles Schwab. Click to access that blog.