Top strategist: Don't sell until 3 things happen

Published Tue, Aug 9 20165:00 AM EDTUpdated Sun, Aug 14 20168:37 PM EDT

Top Wall Street strategist Tony Dwyer warned investors to not throw in the towel on this bull market just because economic growth is slow right now, explaining in an exclusive interview for CNBC PRO exactly when investors should sell equities. "History shows you don't get defensive unless you're going into a recession," Dwyer told CNBC's Michael Santoli in an educational and in-depth interview about how to analyze the stock market. There are three signals that will tell you when to sell, said the chief market strategist at Canaccord Genuity, a global investment bank. To find out what those three metrics are, watch the video above. Also discussed by Dwyer: The top myths perpetuated on Wall Street. Best stocks to own right now. Why a short-term correction is a buying opportunity. PRO subscribers can also read the entire transcript of the exclusive interview below. MIKE SANTOLI: Tony Dwyer is chief market strategist at Canaccord Genuity Ingenuity, that's a global investment bank and financial services firm that specializes in wealth management. Prior to joining the firm he was also a chief market strategist at Collins Stewart. He has a more than three decade career on Wall Street, analyzing the markets, helping investors figure out what to do with their money. And I'm glad he joins us here at the NASDAQ. Tony, thanks a lot, good to see you. TONY DWYER: I can't believe it has been three decades. That makes me sound and feel so old. MIKE SANTOLI: You know, I'm right pretty much in parallel with you. TONY DWYER: I know, you've been interviewing me for that long. MIKE SANTOLI: And I think that you have to spin that, as I'm sure you do, into an asset, right? You've seen cycles. We've seen cycles together. We've kind of gotten a sense of the rhythm of the market. And actually let's start there. I mean, I wonder, I know you're sort of current tactical positioning, but let us broaden it out a little bit to start, and say where does it feel like we're at in this market cycle, in this economic cycle, relative to, gosh, everything you hear out there about how this cycle can't be compared to anything else, it's not really comparable? So, where do you come down on that? TONY DWYER: The old idea that it's different this time. And the one thing that I've found going through the three decades is it's not different this time. It's different in some ways each time, but human nature is always the same. So, for example, where are we in this cycle? Historically it's not the time that creates the cycle, it's the Fed policy and what it does to credit and lending. So, up until the Fed raised rates last December it was our view that we were still early in the economic cycle. And people would look at me like, "You're out of your mind. We're six years into the economic cycle, they don't even last this long." But the real Fed funds rate hadn't changed. It's still negative. MIKE SANTOLI: So, that means the Federal funds rate, the short-term interest rate, is below the rate of inflation? TONY DWYER: Correct. MIKE SANTOLI: That's what you're saying, yeah. TONY DWYER: Correct, it's below the rate of inflation. And that's when the Fed is accommodative. That's when they're lending, and trying to create money supply, and trying to get people like us to borrow and to spend. MIKE SANTOLI: So, it was pretty much early in the cycle, as of, let's say, last December when the Fed moved. But what about the markets? There was this sense out there that the financial markets had kind of raced ahead of the underlying economy. As you say, you know, the bottom of the bear market in March of 2009. We've just about tripled in value from there. Does it still say that the market cycle has a ways to run? TONY DWYER: The only reason, historically, that you want to be a seller of equities, I mean really defensive, sustainably defensive, is when you believe we're embarking or are in a recession. I have three indicators that I use that tell me how close we are, and they each have checks and balances. So, for example, when the real Fed funds rate is below three percent, we've not gone into a recession since the early 1950s. Now, I'm wrong. This is wrong if it's in the Depression era. But so far even in this cycle it's not. So, the real Fed funds rate has got to get above three percent. I'll even call it two percent. We're at minus-one, still. So, that's one thing. Secondly, the yield curve has to invert. Historically, you don't go into a recession until actually an average of 15 months of inversion. MIKE SANTOLI: So, that's when long-term treasury yields are below short-term treasury yields, just to explain? TONY DWYER: What would make a bank not lend, to answer the question in a way that the viewers can absolutely understand. Why would you ever lend me money to lose money as a bank? So, if the money that you're getting, if you're getting it at five percent, you're paying five percent, why would you lend it to me at three percent, to lose two percent? So, you need the Fed to be hiking interest rates aggressively, real Fed funds rate goes up. The yield curve would have to be inverted, so bank lending rates would have to be above what they're lending at. We're nowhere near either of those. And then there's a thing coming out of the Chicago Fed called The National Financial Conditions Indices. It has 105 indicators in it that measure stress in the system. So, if we assume that the argument has been that it's different this time, and maybe we're like Japan, we can go into this deflationary mode. And the Fed doesn't matter. And we can go into recession without an inversion of the yield curve. Surely somewhere in the system, out of 105 indicators that measure banking, shadow banking, and financial markets, you would have some sign of stress. And let January and February, that's the indicator that saved me. I made a horrible call in January and February. I did not get defensive enough. Because I don't believe, and history shows, you don't get defensive unless you're going into a recession. None of those three indicators showed that we're anywhere near a recession. And to this minute they don't show we're anywhere near a recession. MIKE SANTOLI: So, that January and February market panic obviously was reversed relatively quickly after a little while. TONY DWYER: Correct. MIKE SANTOLI: So, in other words, those indicators still didn't steer you wrong, ultimately, to this point? TONY DWYER: That's correct. You know, this is so important. And the things that we've learned over three decades is emotion rarely works. When you can sit back and take a practical look at the indicators. It is hard. You know, when people are panicking, it's pretty hard to say, "Oh, I think you should buy them here." You sound like an idiot. At that point it's more like, "I think you should not sell them here." And I think that's the tack that investors should look at. When you're in a significant decline in the market, anything over five percent, history, even after the crash of '87. History says you don't want to sell that because you will get it back relatively quickly, unless you're heading into a recession. So, again, not to beat a dead horse, but I'm going to do it, real Fed funds rate has to be well above zero, the yield curve has to be inverted, and the Chicago National Financial Conditions Sub-indices have to be showing stress. None of them are happening. MIKE SANTOLI: So, those are all still green lights for investors. What about this so-called earnings recession we've been in several quarters in a row, going on five quarters in a row? Corporate earnings down year over year. Lots of things going on, kind of below the surface, that is causing that decline. And I guess during that the stock market indexes didn't really do a whole lot, right? They kind of mostly went sideways. How do you interpret that when it comes to figuring out where we are in the cycle? TONY DWYER: It's a great question, Michael. I kind of make a joke when I'm giving talks that when you mention the word "microfiche" most people now think it's a biotech company. MIKE SANTOLI: Sure. TONY DWYER: But what it is, is you have to go to the library, anything prior to 1997, to really find information on it. So, I went back and I researched the last time we had an earnings recession in a non-economic-recession environment. It happened to be 1985/1986. And guess what happened then? Saudi Arabia publicly announced that they were no longer going to be the swing factor in the production of oil. And they created a glut of oil. Oil prices dropped 69 percent, which put significant pressure, temporarily, on the cyclical industries, and the banks that was lending to them. So, you had a more than four-quarter recession in earnings. You had an immediate hit to the stock market, I think it was roughly ten to 12 percent. And then from that low in 1986, remember this was a five-month event of that kind of drop in oil prices, you went up 55 percent into the '87 peak. Now, I'm not saying we're going to go up 55 percent. But, holy cow, I'm on the fringe of craziness, and I'm only looking for ten to 15. And I think that's very doable. MIKE SANTOLI: Yeah. So, I mean, obviously a lot of those details seem to match up, right? We did have the oil crash. This time it's mostly energy earnings that have been in freefall recently. And, in fact, it looks like we're going to, you know, be somewhere close to break even on S & P 500 earnings this quarter or next, right? TONY DWYER: Well, here's an interesting stat. According to my friends at Thompson Ivis (PH), and this is going to get the Twitter feed going crazy, if you take energy out of the equation, because we all know that the drop is there. The idea that we're not having any top-line growth. We have a GDP print that was very disappointing last Friday, just over one percent, right? The top-line growth ex-energy, according to Thompson, is 2.7 percent. MIKE SANTOLI: For companies? TONY DWYER: For companies, for the S & P 500 non-energy companies. Now, that's pretty solid. I'm not saying that's solid like it was in an explosive economy, but again we don't want. That's the thing, it kills me when I hear people say, "This economic recovery's awful." And for some of Main Street that's true. And I wish it weren't that way. But, a slow-growth economy has done pretty well, because you have moderate earnings expansion and multiple expansion. And, again, that trend doesn't change easily. TONY DWYER: Multiple expansion, meaning, obviously the valuation of the market, what the market's going to pay for each dollar of earnings has gone up. TONY DWYER: Correct. And this is a line that I know you know well, right? This will end badly. There's no question in my mind you cannot fix debt with debt. I almost got fired in '99, I almost got fired in '08, because I got that negative. Because credit was a mess. The term "this will end badly" has killed more portfolio managers than any other phrase that I know. Because they're right, but it's always so early. So, you look at those three indicators. MIKE SANTOLI: Sure, and that's been the mantra, as you know, for the entire of this bull market, yeah. TONY DWYER: For the seven years that we've been in a bull market. MIKE SANTOLI: Since the crisis, yeah. You did, on a tactical basis, kind of go to a neutral stance on U.S. stocks pretty recently. Walk through where that kind of fits into the overall view? TONY DWYER: Sure. There are certain times, it's funny, when you look at corrections, they're only natural, normal, and healthy until they actually happen. And when they happen by definition it has to bring with it some sense of fundamental change, right? So, I believe we're embarking into this correction territory. I get there because my friend Jason Gilford (PH) a cinnamon trader (?), I'm not that smart. I have a lot of smart friends. You know, he pointed out that when the VIX gets down the CBOE volatility index drops below 12 for the first time in three months. Two weeks later it's up by an average of 20 percent every time. MIKE SANTOLI: So, when it's up that pretty much always means the stock market's down? TONY DWYER: Correct. I am so bullish based on those fundamental indicators I talked about before. The problem is if you start yelling that as the market's in decline nobody's listening. We have an institutional audience in the U.S., and more wealth management overseas. But, I have to convince them that it's okay before it happens. They'll never believe it as it's happening, because they're worried about, you know, business leaving and funds flowing out of their funds. MIKE SANTOLI: Right. So, in other words, if the market's already having a rough time and down a few percent, it's not the time to start to tell investors, "Hey, start getting defensive here. Or don't expect much out of the market." TONY DWYER: Right. Now, I don't believe there's any reason, I think it would be inappropriate for me to say sell the market and go defensive in your sector allocation. But if you're offensive and super aggressive and the market corrects you have no leeway. And I don't know about you, but I'm not good at double-buying. Let's say I get short, and everybody says, "great call," and the market's down, you know, eight percent in the next 15 minutes, that's great. Nobody's going to get the benefit from it. I can't double-buy. So, actually, if I'm short and I buy to get neutral I'm feeling like I made the right call. And then if it rips I'm still only neutral. I just think the best positioning right now, Michael, based on the backdrop, and the election season, and that VIX indicator I mentioned, I think is just to take a neutral, a don't-get-hurt-by-us. And as the market pulls back, or even works off its over-bought condition by going sideways, then you want to get into the game from there. MIKE SANTOLI: And then the assumption is on your part that you kind of resume the uptrend, maybe after a correction. And then getting into next year, you're talking about that ten or 15 percent upside from here? TONY DWYER: I think it's a minimum. Okay? So, here's the stats. That's kind of what makes me different, is if you write a lot of words without a lot of historical backup you're probably making it up. So, here's the backup. We had two 90-percent upside volume days on the NYSE coming off of the Brexit low. Two days in a row where 90 percent of the volume was in upside stocks. You have never since 1950 been negative three, six, and 12 months later, with median gains of over 10 percent, 18 percent, and 29 percent, respectively. Your worst performance six months in was ten percent. So, with three to four percent upside since that indicator went off after the Brexit low, I'd have to be out of my mind to say-- the problem is we think we're so smart. You know, we find the reason. And it's never the reason. So, you just have to be positioned with human nature, history, and the fundamental backdrop of how close in proximity to a recession you are. MIKE SANTOLI: What do you make of the mix of sectors and such that have been working lately on this run up to a new high? Specifically, this huge focus on defensive stocks, on finding yield through stock dividends? Now, other stuff's been working, too. I mean, it's been a broad rally. But just that sense out there that those sectors have out-performed so much year-to-date? TONY DWYER: The best part is energy and materials, they're the two best-performing sectors this year. MIKE SANTOLI: Yes. TONY DWYER: But all we hear about is the defensive-yielding sectors. And God bless, because, you know, the Baby Boomers certainly need that yield. So, I'm not going to disparage that in any way. However, what we like to do is called myth-busters. Financial myth-busters, like the Discovery show. So, when I hear people say that defensive stocks are leading the rallies, that's not good, it creates an environment that makes it a little more risky. That's not accurate. Off of the lows, the February low, or the Brexit low, the more offensive sectors have led. So, you're getting the right leadership when it rallies. The problem is these drops have become so sharp on algorithms and technology trading that it makes it difficult to, you know, have this. The out-performance has been in the consumer staples, utilities, and telecom, pure. But the rallies are led, the rallies themselves are led by the offensive sectors. MIKE SANTOLI: Right. So, it's almost as if those defensive groups kind of, you know, support the market when the other one's are backing off, right? TONY DWYER: Correct. It's like the hedge fund mantra, right? I'm not going to make as much on the upside, but I'm going to lose you less in the downside, creating that preservation of capital that can launch you to better compound returns going forward. And that's basically what the consumer staples, telecom, and utilities have done. Is they've created an environment that protects the money as the market's swooning, so that your performance is pretty good. MIKE SANTOLI: Sure. So, what sectors would you emphasize here for this environment? TONY DWYER: Again, once we come off this neutral camp we want to buy them into weakness, not on the next tick. We like the offensive sectors. My favorite sector is the financials, which admittedly has been a horrible call up until recently. But, again, when I look back and I use history as my guide, the last time we had a European debt crisis was 2011. The last time the yield curve got as flat as it is now, or even a little bit flatter, and the ten-year-note yield dropped to the current level of under 1.5 percent, happened to be the best time to get long financials. So, again, unless you believe that the Fed is going to aggressively raise rates, to the point where the ten-year trades through the short end, our guess is a lot of the negative, or the pessimism about rates is already reflected in the financials. So, you couple that with the information technology. And you've done a great job pointing out high-multiple versus low-multiple areas, which, you know, is kind of in line with this. And also you want to be in some of the more cyclical plays, like a basket of industrials, materials, energy. MIKE SANTOLI: So, on the financials the call really is not that the fundamentals are so wonderful right now. But, that the stocks priced in a pretty grim scenario, you get a little bit of relief on the rate side, and all of a sudden those stocks work. TONY DWYER: Right. And you get loan (?) demand. Just go back and, you know, do a search for the last time that ten-year note rates were here. And the commentary that was around Wall Street was not, "Hey, guess what? Rates are going from 1.42 percent to three percent." And they did. Nobody thought, "We're going back to three percent," when they were at 1.42 percent. Nobody saw a steeping of the yield curve. Now, maybe it doesn't. History suggests that it may. MIKE SANTOLI: Sure. I mean, what are the questions you feel like you're getting constantly from investors? Just as a matter of pushback. Are they basically saying, "Look, you have all this debt around the world, it's negative interest rates, negative yields. Doesn't that change the whole equation somehow for what the financial markets can offer?" TONY DWYER: It does. It's pushing money into more risk. It means you're going to get more upside. I mean, how can you believe that the corporate bond market, I mean, really? Some of these companies are trading at the yields they're trading? That's insane. But that's what happens when you have such low rates, is you have a push. This is how it ends badly. You get it to levels that it should never be at. And it does end badly when the Fed, again, creates a recession. Again, we're not near there. That question, of course, what's going on with the political environment, and can it really influence the stock market. And my thought on that is we already have the most powerful woman in the world, Janet Yellen. You know? Again, you look back over prior cycles and presidential cycles, the most important person as it came to economic activity, or the stock market, or a fixed income market, was Alan Greenspan, then it was Ben Bernanke, and now it's Janet Yellen. And I think it's really important to remember when you see an insane tweet from somebody, or a return comment from another person, you know, I can't wait for the first debate. It's going to be very entertaining, likely. But, I really don't think it's going to have a significant long-term impact on economic activity or the market. And, in addition, I'd seen one report where if you take 2008 out of the data it changes the fourth year of an election cycle data. Which is kind of an important point, as well. And it proves it. MIKE SANTOLI: So, in other words, it's generally an upside bias, if you took the '08 out. TONY DWYER: If you took the '08, because we're not in a financial crisis. Even the bears would admit we're not in a financial crisis. It's the funniest thing, most of the bears are good buddies of mine because we were on the same trade then, and, you know, I was at one point a perma-bear. But, you know, when you look at what creates that kind of sustainable negative economic reaction, by definition it has to be money. We had the fiscal cliff, a European debt crisis times three, and a taper tantrum, and we still didn't have a recession. Surely, Michael, if we were in an environment that was like Japan, and you could have a recession without an inversion of a yield curve, or a spike in the real Fed funds rate, it seems to me it would have happened when the global economic backdrop was much worse than it was today, and the banks were less capitalized. MIKE SANTOLI: Yeah. What about the Fed call at this point? You say if they decide to, you know, essentially trigger a recession. Now, clearly that's not their intention. But do you believe that've kind of sidelined themselves intentionally here, in not really wanting to sort of push the previous effort to get rates higher? TONY DWYER: I think they have. I'm hoping that they've acknowledged that debt is the governor, interest rates are the governor on the engine. So, for example, when we bumped up to three percent, that's probably what caused the malaise in the economy post-2013/2014. Was that that had an impact on lending. And on my ability, I mean, I'm refinancing my debt. I don't know if you are, most people are. You got it to a really low level. That is what keeps a cycle going. For example, a steel company that was being priced in the thousands for credit default swaps. So, the insurance on its bonds were saying it was going to default. Raised $380 million, and cut their interest rate significantly, and extended their maturities for another six years. So, instead of it ending badly because they had too much debt and not a perceived great business, instead of having it mature in 2018 it matures in 2022 or 2023. Right? So, all the Fed does, this is, I think, the exciting part of where the Fed makes a mistake that viewers might appreciate. They assume that you or I, when we refinance our debt and have our interest expense saving, is going to take that interest expense and pay down the debt. Well, now we buy more stuff. That's just the American way, and that's what happens. And then eventually you have too much leverage, so it only takes that governor on the engine. It only takes a little tweak to shut it down. So, I'm hoping that the Fed has seen that there's a quick reaction to that rate move, and doesn't invert the curve. MIKE SANTOLI: If you think back to common lessons, or the most important lessons that you've derived from all this time of watching markets and seeing investors, how they behave and everything else. What are some of them that really come right to top of mind? TONY DWYER: The most important one for me is that the market is always smarter than me, and everybody I've ever met in this business, right? That's the most important thing. We complicate something to the Nth degree with our, you know, academic minds. So, the biggest is do my own research, for the viewer, do your own research. Right? Make sure that it's backed up. That you're not, you know, kind of taking a data point to make it fit your story. And to just not overthink it. And again, going back to the stock market, right? Capitalism hasn't failed. The way that sometimes it reacts in the stock market has. For example, are you buying a company because it has a good symbol and has three points upside? Or are you buying a company because I want to be partners with Mike Santoli, right? And when I think of when I buy a stock or a company, I think of, "Do I want to be partners with the leader of the company? And do I want to be in the business that they're in?" And I think the biggest lesson is I've not yet met a sustainably great trader. You know? We all make mistakes. I'm very, very good at them. The upside is you try not to make the same mistakes twice. MIKE SANTOLI: Before we finish, the idea that the market knows more than all of us, where does that leave you in terms of trying to stay on the right side of it? I mean, do you just simply defer to what the market's message is at any given time? TONY DWYER: Until human nature takes over. So, again, if you have a core fundamental thesis, right, that if nothing in that thesis has changed, real Fed funds rate hasn't changed, yield curve hasn't changed, Chicago Fed Indices haven't changed. So, if the market goes down 12 percent, why am I changing? Right? And all of a sudden all the indicators say every time it's gotten this bad it turns around. So, I think it's a practical application of some of these lessons that really keep you from, "Oh, the market's right, it's going to zero, and I'm going to lose all my money." I know me. When I'm living in a cardboard box and I'm about to lose my job in my head, it's probably a good time to be a buyer. And I think that's, for me, the greatest lesson of investing. Is not to react to my own emotions, but to react to what I see and what I can back up practically. MIKE SANTOLI: And, I guess, until proven otherwise just assume it's not different this time? TONY DWYER: Because this cycle has worked. Like, even the two 90 percent upside volume days that I mentioned before, where the market's not been negative three, six, and 12 months later, it happened in 2013. And the market was up, three, six, and 12 months later. That's one of those human nature things where you can tap a little bit of history. And, again, the fundamental backdrop, it changes a little bit, but Fed policy, you know, the stuff I've mentioned far too many times already. As long as that's in good shape, it's not whether you're a buyer, it's where you're a more aggressive buyer. Just like on the other side of the trade. When credit's shut down, it's not whether you're a seller, it's where you're a more aggressive seller. MIKE SANTOLI: Right. Actually, let me pin you on one more thing, which is I'm sure something you get pushback on, which is aren't stocks unusually expensive right now relative to their earnings or whatever other metric you want to do. I'm sure that's something that you hear some of. TONY DWYER: I hear a lot of that. And I think the only way you can answer that is to find a way to compensate for inflation. So, what we've done is we use a combination of the core inflation rate, and the operating earnings PE. Which is currently at about 19.5 times. When you look back at history that needs to get well above 20, usually 22, the combination of that number. So, let's call it a core inflation at two percent. It's not, but, you know. And the operating earnings PE is at 18 times. So, you're at 20. So, you need to get that to 22 before you really believe that you're at a peak in the marketplace. So, and I had made the case, as you know, that the market was undervalued. It's not undervalued. Valuation is a horrible, horrible, horrible way to invest. MIKE SANTOLI: Yes. TONY DWYER: Right? Because it trends. What you want to do is you want to follow the trend until you can no longer back it up. So, for example, in the early 1980s, late '70s, you know, inflation is at 14 percent, and the operating earnings PE is at eight. Twenty-two. So, you find a way so that you can judge the current environment relative to historical environments and risk tolerance. So, our view is ultimately we're going to at least 22 on the combined number, who knows where you can go? If you sold that, and you'd have sold it, I think, in 1996. That wasn't only a bad trade it was a career-ender. I almost got fired, because I got bearish in September of 1999. Thirty percent too early. MIKE SANTOLI: Sure. TONY DWYER: Right? Now, it happened to be a good call ultimately. But, you have to be careful with valuation as your argument for or against anything. MIKE SANTOLI: All right. Tony, excellent advice. Thanks very much. Appreciate it. TONY DWYER: Thank you, Michael. MIKE SANTOLI: For CNBC Pro Talks, I'm Mike Santoli. Transcript Source: Transcript Associates

"History shows you don't get defensive unless you're going into a recession," Dwyer told CNBC's Michael Santoli in an educational and in-depth interview about how to analyze the stock market.

There are three signals that will tell you when to sell, said the chief market strategist at Canaccord Genuity, a global investment bank. To find out what those three metrics are, watch the video above.

Also discussed by Dwyer:

The top myths perpetuated on Wall Street.
Best stocks to own right now.
Why a short-term correction is a buying opportunity.

PRO subscribers can also read the entire transcript of the exclusive interview below.