Charles Schwab's chief strategist Liz Ann Sonders sees 'slow melt-up' in 2017

Published Tue, Jan 10 20172:22 PM EST

Liz Ann Sonders, who sets the tone for $2.7 trillion of investors' assets as chief investment strategist at Charles Schwab, shares her investment outlook for 2017 during an extensive strategy session with CNBC's Mike Santoli . "I don't put all the credit on the results of the election for the rally in the stock market," said Sonders, who thinks a solid foundation for stocks was already in place given the positive trend in economic data and a bottom in corporate earnings. "If you look at the improvement in the economic data, it predated the election. So that the bottom in, say, the Economic Surprise Index put out by Citigroup, occurred in mid-October. So I think some of this move reflects the economic data and earnings data having already approved at this point," she said. She said just as in 2016, there could be a "slow melt-up" for stocks this year, and investors can profit from it by seeking value strategies. "Fundamentally, I think value makes sense, just don't put blinders on in terms of where you find that value," Sonders said. Other topics they discussed include: Her favorite sectors and asset allocations for 2017 The investment strategies that make most sense for investors Investor sentiment measures and what those metrics show Market valuations, her outlook for earnings, yields and fixed income PRO members can also read the entire transcript of the exclusive interview below. (Editor's note: The content below is from a third-party service and there may be some minor transcription errors. Watch the video for the exact quotes.) MIKE SANTOLI: Liz Ann Sonders is chief investment strategist at Charles Schwab, where she's responsible for analyzing and interpreting the economy and the markets. Liz Ann was named one of the 25 most powerful women in finance by American Banker U.S. Banker Magazine and joins us now to share her investment outlook for 2017. Liz Ann, good to see you. Thanks for being here. LIZ ANN SONDERS: Thanks for having me. MIKE SANTOLI: So let's try to set the scene for us, I guess, here as we get into the year. Stock market in the U.S. had a pretty good finish, a pretty good gain for the year actually. Most of it coming after the election, but also coming at a time when a lot of the global economic indicators were perking up. And maybe the market was trying to figure out if earnings were going to come back for U.S. companies. So I guess trying to sort these factors out, what's going to matter most in 2017 for the markets? LIZ ANN SONDERS: So I don't put all the credit on the results of the election for the rally in the stock market. I think if you look back to the February period when the market bottomed after that really ugly first six weeks in the year, you could liken that to the bottom in earnings occurring also in the first quarter. And then you ultimately came out of the earnings recession by September. And if you look at the improvement in the economic data, it predated the election. So that the bottom in, say, the Economic Surprise Index put out by Citigroup, occurred in mid-October. So I think some of this move reflects the economic data and earnings data having already approved at this point. So looking ahead into the remainder of this year, I think it has to bear out. The good news is expectations for corporate earnings are up at about 13% year over year. That's consensus. That doesn't really incorporate much that is anticipated to come from the Trump administration, whether it's corporate tax reform or even personal tax reform and infrastructure spending. So I think if we can start to see a kicker there in earnings and we don't get higher up the priority spectrum some of the anti-growth protectionism, tariffs, then I think we're in pretty decent shape. MIKE SANTOLI: So despite the fact that most of the conversation around the markets has been about what might come out of Washington, we're talking mostly about a cyclical rebound in corporate earnings that seems like the markets are banking on. LIZ ANN SONDERS: And a lot of it has to do with the turn in the energy sector. So in Q1 of last year, the energy sector had a negative 350% or so year over year decline in earnings. And given the move back up in oil prices, we've obviously seen that move into the significant positive. So energy alone explains a lot of the move from earnings recession in the first part of last year to 13% growth. But you could tack on, you know, quite a few additional percentage points if some of these reforms can get done in the first half of the year. And most analysts haven't started to incorporate that into their 2017 estimates. MIKE SANTOLI: Right. So it's not what the market is really hinging on, but it would be sort of a bonus if it happened. LIZ ANN SONDERS: Exactly. MIKE SANTOLI: And I guess the question is how much of that earnings rebound has now been accounted for by the market, right? I mean, if we can explain what's happened, let's say, since February or even since the fall with what's going on with mostly with the economic fundamentals, has the market kind of figured it out and now we just have to-- LIZ ANN SONDERS: Well, you know, valuations LIZ ANN SONDERS: actually haven't changed all that much, because in the first half of the year, you had valuations expand simply because of valuation expansion. You were getting none of the heavy lifting being done by the denominator in the equation E. And then in the second half of the year, finally earnings started to pick back up. And that has helped to improve forward multiples for 2017. I think they're not at an unreasonable level right now, relative to say 20-year median. The forward P/E is a little bit north of that long-term median. I think the key in terms of keeping valuations where they are right now and having a positive outlook means that inflation has to stay relatively in check. Because there is a very close relationship between inflation and P/E ratios. Earnings are more valuable when inflation is low. So we're in a reflationary era. I think that's a good thing. But I think too much of a good thing in a condensed period of time, that would be the risk to valuations if you start to have to put that pressure down on P/Es, because of rising inflation. MIKE SANTOLI: It's interesting. It seems like we're in a similar situation that you just described there with a few different drivers of the market. So you mentioned inflation is kind of in the zone where it's rising, but still at a reasonably comfortable point. Similarly, bond yields, Treasury yields, doing something similar, maybe oil prices you could order, maybe Fed expectations for how much they might tighten. So are we just kind of in this sort of sweet spot? LIZ ANN SONDERS: Well, we're definitely in a sweet spot right now anyway in terms of bond yields, the first thing that you mentioned. And I think that's an important factor. Because one of the common questions I get from a lot of our investors, probably because they're taught it figuratively in markets 101 that rising bond yields is negative for the stock market. And in general, the two are inversely correlated. However, there have been three eras historically (we're in the third one right now) where long-term correlations between bond yields and stock prices, i.e. 10-year rolling correlation is very much in positive territory. We had it in the 1930s. We had it in the post-World War II era. And then we're in another era right now. And the characteristics of those eras, which you were coming from a deflationary environment into an inflationary environment. So when bond yields were rising, they were rising from a very low base, certainly the case this time. And they were rising because of a pickup in economic growth, positive for the stock market. And they were rising because it was putting deflation further in the rearview mirror. Deflation, of course, being toxic for equities. So you have this sort of tailwind behind stocks in the early stages of a bond yield increase from a low base going from deflation to reflation. At some point, it starts to choke off growth. I just don't think we're within a near-term time frame. MIKE SANTOLI: Sure. Yeah, I mean, obviously, people have taken a stab at trying to fix what that level might be, that pain threshold for yields. I mean, it's hard to really know. But of course if you look back in a very rough way, ten-year treasury yields would have approximated, like, the nominal GDP growth rate. LIZ ANN SONDERS: Right, exactly. MIKE SANTOLI: And we're not really close to that. LIZ ANN SONDERS: And I would keep an eye on the shape of the yield curve, you know? I don't think we have changed the so-called rule that an inversion or a move toward an inversion sends a very negative signal about both the economy and the stock market. So I think it's the shape of the yield curve and the relationship between short rates and long rates that matters more than just the level of long rates. MIKE SANTOLI: Sure. And what about the Fed's role in setting the shape of the yield curve, at this point? I mean, can the market absorb what's now I guess penciled in, like, maybe three rate increases this year? LIZ ANN SONDERS: Yeah, what's interesting about that is I've looked at historic Fed tightening cycles. And you can categorize them in one of two ways. Either a slow cycle or a fast cycle. This clearly has been a slow cycle with only one hike in 2015 and one in 2016. But the normal cycle, like the one that preceded this one, is fast, you know? In the '04 to '06 cycle, the Fed raised rates 25 basis points, 17 consecutive times at every consecutive meeting. But what's interesting is if you look at how the market behaves in the first year of a slow tightening cycle, it behaves very well. Much better than if the Fed is moving quickly. Interestingly though, when you move into year two in the cycle, the market performs worse if the Fed continues to act in a slow manner. It tends to do better. It's intuitive in the sense that the market gets comfortable if the Fed is moving slowly, can sort of start to feel confident that they're not going to cause the economy to dip into a recession. But if they continue to act slowly, it probably means there's something really structurally wrong with the economy. So I think that's what we should look for. The fact that the market and the Fed are basically in agreement that we're probably going to get about three hikes this year, I think if we stay around there, I think the market could easily digest a pace of increase at that level. MIKE SANTOLI: One of the other themes that's really in the air right now is that investors will make some kind of a wholesale shift, right? They'll look at the prospect of yields going up and bond values potentially going down and finally move a lot of money toward the stock market. LIZ ANN SONDERS: The great rotation. MIKE SANTOLI: Exactly. Now for one, I mean, I think there's a lot of argument on both sides of whether something like that is likely to happen. But also, would that be always a positive thing if all of a sudden we saw a mad rush into stocks? LIZ ANN SONDERS: So I guess it depends on the pace. For the last several years, we have not been of the view that we were going to get this great rotation. Simply because we felt that we were in a lower for longer kind of interest rate environment and that there wasn't going to be that impetus for a massive outflow of money out of the fixed income side. And I don't think we've really changed our tune, although we definitely have a bias toward equities over fixed income. And we have seen a bit of a shift. You know, you've had well over a trillion dollars of money that's gone into bond funds in the last six or seven years. And on a net cumulative basis not a single dollar of new money has come into the U.S. equity market, even if you include exchange rated funds. So there's a lot of runway ahead of us, whether we ultimately look back and call it a great rotation in the sense that it was sort of an equivalent massive outflow from the fixed income side. I'm not so sure that that's going to happen. It's certainly not our forecast. But what we may be finally starting to see, for the first time in this entire bull market, is an environment where not only attitudinal measures of investor sentiment have improved, but you're actually seeing it in the behavior of investors too. At some point, it may signal that there's a bit too much froth. But when you've had eight years of outflows and a few weeks of inflows, I'm not quite sure we're at that point yet. MIKE SANTOLI: Sure. It's interesting. I've tried to maybe do a thought experiment about this and say, in aggregate, if it was a single investing client, right? You have the allocation, all that's in bond funds or bond flows and equities. The equity market has gone up so much that you've kind of, you know, stayed in. If you were exposed to stocks at all, it kind of did its rotating for you. LIZ ANN SONDERS: Well, that's why if you look at household's exposure to equities, the good news is it's not at an extreme. But it's up quite a bit off the lows. And I show that chart a lot when I'm giving presentations to investors. And they'll often say, "But that chart contradicts what you just said, which is that no net new money has come in." The point is that the existing money there has had massive appreciation in the last eight years. So it's grown as a result of that. And that's why you don't see these extremely low invested positions by investors. Because what they do have has had that appreciation. MIKE SANTOLI: And luckily, I would say, most clients weren't at zero for stocks, hopefully. LIZ ANN SONDERS: Hopefully, yeah. MIKE SANTOLI: You mentioned you have a bias towards equities over fixed income this year. What are the other tilts or what are the other themes that you think are going to be important? LIZ ANN SONDERS: So at the cap level, we have a slight bias towards small cap. Our overweight to U.S. equities relative to an underweight to developed international equities is both an overweight to small and large cap. But within that, you know, personally, I have a little bit of a bias toward small cap, just because of the domestic orientation. Valuations are still somewhat reasonable. I think the momentum is clearly with small caps. We don't actually publish ratings on growth versus value. The primary reason being that I actually think the fundamental of value makes a lot of sense right now. When growth becomes more ample broadly in the economy, that's when value tends to do better. It's a little bit opposite of what a lot of individual investors think. They think when growth is more ample, go for the growth stocks. But it's when growth is more dear that you need to look for growth. When it's more ample, it's easier to find. No reason to pay up for it. You might as well look for value. The rub comes in that at times you can say, "I think value stocks will do well." But where are you going to find value isn't necessarily in the stocks that are housed in the value indexes. For instance, two underweights we have at the sector level are utilities and telecom. Classic value names, but that's not where the value is right now. That's actually where the excess valuation is right now. So fundamentally I think value makes sense, just don't put blinders on in terms of where you find that value. The two overweight recommendations we have at the sector level are financials and technology. Technology we've had for awhile. Financials was a nail biter in the first half of the year. Not a great call-- MIKE SANTOLI: Of last year, sure, yeah. LIZ ANN SONDERS: being overweight. Right. But clearly has been the right place to be more recently. MIKE SANTOLI: So if you think, you know, the market and the Fed are kind of in tune, if you think inflation looks like it's on a decent zone right now, what would be the risks that you would point to? You did mention before, you know, some of the stuff you might get policy wise that's not helpful. LIZ ANN SONDERS: Right, exactly. So I think, you know, protectionism, tariffs. Or if say you do start to build into the numbers, either GDP numbers or earnings numbers, a lot of stimulus, whether it's through tax, regulatory reform, or through actual infrastructure spending. If there's too much enthusiasm that builds in the early part of the year and then there's the disappointment if it doesn't actually happen in the first part of the year. That's a risk. And then, of course, the dollar. Now I think that the recent move higher in the dollar has been less harmful to the equity market for a couple of important reasons. Number one, in the last several years, every time the dollar strengthened significantly, it caused sort of this ripple effect in tightening financial conditions. You saw it in rising equity volatility, weaker equity performance. You saw it in the yield curve flattening. You saw it in credit spreads going higher. This dollar move has been a bit different in that you didn't get those other factors. So it didn't broadly tighten financial conditions. It didn't cause the Fed to back away. And I think it's also because the reason for the strength in the dollar (to use well-worn analogy) it's no longer that we're the, you know, cleanest shirt in the pile of dirty laundry. It's actually a positive growth surprise. And that's a very different backdrop. But, you know, too much of that obviously would start to hurt multinationals on the export side. And if it rallies significantly, you start to see these other factors tighten financial conditions. The Fed steps away. And that may cause some concern. So-- MIKE SANTOLI: You know, I was also just looking at the dollar index, right, a trade-weighted dollar index. Even though it's up at a high versus 12 months ago, it's actually not as much of a gain as it was a year ago, when it had really gone up violently. LIZ ANN SONDERS: Right, because we had the move up in the dollar into the rate hike of December of 2015. And then it kind of rolled over again. And this rally has really just brought it back. It did break out a little bit. If you look at a really long-term, you know, 30- 40-year chart of the dollar, you'll see two major dollar bull markets in the 1980s and the 1990s. And in the context of those, this one is still somewhat muted. MIKE SANTOLI: I also wonder, I don't know if this really would qualify as a risk factor, but the specific composition of a corporate tax reform package. I'm kind of interested in the intent of some of the stuff you've seen on paper right now, right? Which is to strongly encourage companies to invest in domestic production, to not rely on debt. I mean, all these things. Who knows what survives in a final proposal. But, you know, it would seem for a lot of very large companies to kind of upend their balance sheet, their supply chain, what they've tried to assume all along about how they would run their business. So I don't know if that really is going to matter. But I would wonder if there's a shape of things that you'd prefer to see in terms of how corporate taxes are-- LIZ ANN SONDERS: Well, I'd prefer to see maybe some temperate enthusiasm about if there's some sort of repatriation of benefit that for some reason that all that money is going to go into long-term capital spending projects. And the reason why I think I'm a skeptic on that is because that cash horde that's sitting overseas, we have a similar cash horde that's sitting here. So why wouldn't that money have been going to work? This idea that that's going to leapfrog the already domestically housed cash horde and go to work in the types of projects that we would like to see. I think more likely it will go to where cash has gone in the last several years already, which is buybacks, maybe some M & A, some debt paydown I think is another place where you'll see some of that money put to work. Because corporations made the rational decision in light of what the Fed did to borrow even though they didn't need to to fund things like buybacks. And now that rates are going up, they may take this opportunity. So I hope we-- MIKE SANTOLI: Sure. I mean, a lot of companies, I mean, Apple with a couple hundred billion dollars could easily have repatriated it, but instead borrowed against it, right-- LIZ ANN SONDERS: Absolutely. And, again, it was a rational-- MIKE SANTOLI: Exactly. LIZ ANN SONDERS: Decision. But in terms of the math that could accrue to corporate earnings. So we've obviously got the highest corporate tax rate in the world. But the effective tax rate, at least for S & P companies, is around 27%-28%. That said, even if you assume more conservative move down to, say, 20% tax rate instead of 15%, that's still a big difference. You know, 27% down to 20%. So it does matter. And I think it matters to corporate earnings. It matters to the bottom line. I just don't think it's going to matter in terms of an immediate rush to the capex cycle that many hope for. MIKE SANTOLI: Yeah. And just as we wrap up, you did mention that it doesn't seem as if there's this huge upwelling of enthusiasm long term for the market. But you have noted that some sentiment measures look a little bit elevated. This is more on a tactical basis, I guess, as we enter the year. What should we be looking for there? LIZ ANN SONDERS: So the attitudinal measures are different than the behavioral measures. So there's, you know, lots of indexes that measure attitudes of investors. Some of the more popular would be A.A.I.I., American Association of Individual-- MIKE SANTOLI: Yeah, surveys and such, right. LIZ ANN SONDERS: Investors, right. Investors intelligence, which is newsletter writers. So just asking investors or reading what the newsletter writers are saying. And that's just a measure of attitude. Those sentiment indexes swing much more wildly. And they tend to swing very consistent with what the market is doing. The behavioral measures like fund flows obviously tell a different story. But there's one interesting set of sentiment indexes that I follow that's put out by Sentiment Trader. And it's their labels for this, their "smart money, dumb money confidence." And they actually look at what cohorts are doing. So the smart money confidence folks are the big position traders, the commercial hedgers. They're the non-contrarian indicator. You tend to want to follow what they're doing. And then the dumb money tends to be the smaller odd lot investors. And there is a pretty big spread between those right now in that the dumb money is quite confident right now. And the smart money less so. So that type of thing tends to potentially set you up for a bit of a pullback, which frankly I think would be a healthy thing. As lovely as melt-ups feel at the time they're happening to the extent you're long, they don't tend to end very well. So if I had my druthers, it would be sort of a two steps forward half a step back kind of market in 2017. MIKE SANTOLI: Uh-huh (AFFIRM). Yeah, and as a matter of fact, it reminds me in some respects, just in terms of the shape of how this rally has gone, of after the Brexit vote last year. You had this very sharp rally. And then it flattened out for awhile. And you had some of these sentiment concerns. I think you only probably had a 3%, 4% pullback or something, and then up from there. LIZ ANN SONDERS: But what's nice is you can sometimes have those pullbacks over a more extended period of time. So you have a correction in time more so than price. That's a really healthy kind of environment. I would take that, you know, any day, all day. MIKE SANTOLI: Right, yeah, you just kind of have to wait it out. And then you get another bit of good news. Liz Ann, thanks for much for your time. LIZ ANN SONDERS: Thanks, Mike. Thanks for havin' me. MIKE SANTOLI: Appreciate it. For CNBC Pro Talks, I'm Mike Santoli.

"I don't put all the credit on the results of the election for the rally in the stock market," said Sonders, who thinks a solid foundation for stocks was already in place given the positive trend in economic data and a bottom in corporate earnings.

"If you look at the improvement in the economic data, it predated the election. So that the bottom in, say, the Economic Surprise Index put out by Citigroup, occurred in mid-October. So I think some of this move reflects the economic data and earnings data having already approved at this point," she said.

She said just as in 2016, there could be a "slow melt-up" for stocks this year, and investors can profit from it by seeking value strategies.

"Fundamentally, I think value makes sense, just don't put blinders on in terms of where you find that value," Sonders said.