Download Liz Ann Sonders, Charles Schwab`s Chief Investment Strategist, and

Liz Ann Sonders, Charles Schwab’s Chief Investment Strategist, and Greg Valliere, Potomac Research
Group’s Chief Political Strategist, opened Schwab’s 2013 IMPACT Conference which began in
Washington, DC on November 10th.
Liz Ann Sonders
Liz Ann began her remarks by recounting a recent cartoon in the New York Post. President Obama was
behind the lectern contending, “If you like the health insurance you have now, you can keep it, period. If
your name is not Period, you are out of luck.”
Rationally Optimistic
Liz Ann continues to see positive forces driving the stock market higher and continues to be very
optimistic. With a bullish stance since 2009, she has been labeled as a perma-bull by some. [We know
this characterization is not accurate. Pointing investors to the inverted yield curve and deterioration in
housing statistics, Liz Ann was a lone voice sounding the warning trumpet in 2006 shortly before the
housing market began to unravel.]
A slightly shrinking number of bears contend that underlying fundamentals don’t justify increases in
stock market prices. This camp argues that the market has been pumped up by easy monetary policies.
Liz Ann can point to a lot of reasons why the market has gone up in line with fundamentals
Stock market valuations are reasonable on an earnings basis. Dividends have done some heavy lifting.
Interest rates remain low. Market technicals remain positive. Yet, the wall of worry is very much intact
and has been since March 2009 when the secular bull market (so identified by Liz Ann) began.
The recently released third quarter growth in GDP of 2.8% was decent. While we may have to give back
the 0.8% in inventory increase in the months ahead, other positive factors will kick in. The boom in tax
receipts tells a bigger story. The best so far is residential housing. Capital spending and exports also
improved. If you remove the GDP drag from public sector deleveraging since June 2009, the economy
grew at 3.2% versus 2.3% including the drag from government spending.
Liz Ann expects employment to reach an all-time high next summer. Within a few months, we will hit
private sector employment highs.
Emerging Markets
While no one is bragging about pace of growth in the U.S., it is the trajectory that matters. Emerging
markets have a higher growth rate, yet stock markets in emerging markets lagged developed market
performance. Slower growing developed market stock prices are up 28% year-to-date while emerging
markets have declined 2.8% year-to-date. China investment as a percent of GDP is likely topping out
away from investment led GDP growth to consumer spending led growth.
Correlations between asset classes are coming down. During and coming out of the crisis, everything
moved together, but Liz Ann believes the commodity super-cycle ended in 2010. The impact this has on
specific countries depends on whether the country is a commodity producer or consumer.
Private Sector Deleveraging
Household debt to income has come through the long term trend line to pre-bubble levels. Household
deleveraging is no longer delivering a drag in the economy.
Incredibly Shrinking Deficit
While budget woes continue to plague Washington, the trajectory of receipts and spending are in the
right direction. Indeed, the deficit could be under 3% of GDP. The debate in Washington is centered on
which needs to give—taxes or spending. Meanwhile spending as a percent of the economy is still above
historical norms.
Many Americans do not understand the difference between the federal deficits and debt. Debt is the
cumulative effect of running deficits. The federal debt is still growing, albeit at a lower rate.
Our total debt to GDP is over 280%. If one includes unfunded entitlements, that number rises to
between 700% and 800%. Both sides of the aisle know what to do to fix the debt. They just don’t know
how to talk about it with voters and win elections.
Fed Policy
Janet Yellen will likely be more willing to step in and say we need to do something here. She will provide
continuity to the current policy. The earliest she expects tapering to begin is December. Probably
tapering will begin next year, $10 billion at outset. Inflation remains low because velocity of money
remains flat-lined. The big question is, “What will the Fed do when velocity picks up?”
Velocity of money will pick up with animal spirits. Lending as a ratio to bank deposits quantify animal
spirits. There continues to be a lending gap, which is especially prevalent among large banks. Animal
spirits are picking up in small banks where lending is up 13.6%.
The Manufacturing Renaissance
Many factors account for the resurgence in U.S. manufacturing. As emerging market labor costs
continue the increase, restrained U.S. labor costs take on additional importance. The ease of doing
business survey ranks America #4 when compared to other countries. When the total cost gap in
shipping, logistics and duties reaches 15%, most economists say it is no longer economical to build
overseas. We have a 5%-25% export cost advantage over not just China, but other emerging market
countries. We’re starting to see the manufacturing renaissance show up in economic statistics with
manufacturing now accounting for 13% of GDP.
Valuation
The stock market looks reasonably priced as measured by the average P/E ratio. The market is currently
priced 1 point below the historical average. The market rarely stops at the average; it always
overshoots. Low inflation supports higher valuation
One troubling factor for the near-term is that “dumb money” (odd lot traders) confidence has spiked up.
Liz Ann believes a market pull-back would be healthy as it would elongate the secular bull market. After
all, “melt-ups” rarely end well. Liz Ann would love to see a 3% to 5% correction that brings out bearish
sentiment.
Given the number of underinvested bulls (hedge funds, endowment funds, pension funds), Liz Ann
thinks we are no worse than in the middle innings of a secular bull market. Markets typically move from
the despair experienced at bear bottoms, to hope, relief and then optimism before taking off into bull
market territory with enthusiasm, exhilaration and then with euphoria at market tops. Market
sentiment has recently been between relief and optimism. A near-term pullback would elongate the bull
market.
*****
Greg Valliere is an optimist. He sees positive big themes coming out of Washington that have been
moving the stock market. Investors should focus on the big themes. We are not going to have another
government shutdown. Republicans don’t want another shutdown. The markets have gotten used to
Washington crying fiscal policy wolf evidenced by the lack of market reaction during the latest
showdown. There was no fiscal cliff, no debt crisis. The media gets us excited, stirring the pot to get
people agitated. He recommends advisors tell nervous clients to turn off CNBC. The media is unwilling to
look at great positive themes: the resurgence of American manufacturing, energy independence on the
horizon, strength of corporate balance sheets, rebound in housing and autos—all great themes. Great
themes extend to Washington. Greg sees three positive great themes coming from Washington.
1. Accommodative Fed
First, we have the most dovish fed ever. Janet Yellen will get confirmed. Two hawks on the Fed board
have been replaced by two doves. Even the doves would like to taper. We have had enough already of
QE3 given its mixed picture of success. Jeremey Stein who was appointed to the Fed Board in 2012 to
fill an unexpired term ending in early 2018 recently said the Fed should look for bubbles. The Fed will
begin focusing on when to raise fed funds rates. Taper will probably happen sometime early next year,
though less likely, perhaps even in December. Markets have done just fine during the most recent taper
talk. The biggest inhibitor to taper is inflation, which is still too low as measured by the Fed’s favorite
indicator. Inflation by that measure is up only 1%. Unit labor costs remain subdued.
The bigger story is that the Fed will not be dissuaded from its dovish stance. Yellen is just as dovish as
Bernanke. If she saw TIPS spreads move, the Fed may move earlier, but expect 2 to 3 more years of
loose money. Notice to investors: don’t fight the Fed which will remain extremely accommodative.
2. Fiscal Restraint
Not well understood is the firm mood of fiscal restraint in Washington, the second big theme coming
out of Washington. The deficit fell to $400 billion. Expressed as a percent of GDP, the deficit represents
a little below 3%, close to the post WWll average. In 2016, receipts and expenditures are projected to be
close to break even with the possibility of running a surplus that year. This contrasts to deficits of more
than $1 trillion [7% of GDP] just three years ago. [Deficits are expected to head up again in the last years
of the decade.]
Receipts tell the broader good story. Corporate and individual taxes exceeded expectations while the
spending remained restrained under the sequester. With Republicans in charge of the House, new
spending will not happen. Under the sequester, spending cuts are real, in contrast to past “cuts” which
were really just a reduction in the rate of spending growth. Spending will continue to decline either
through the continuing sequester or a budget deal. The earliest the Republicans could kill Obamacare is
in the spring of 2017 if they win the White House.
In wake of the agreement reached in October to end the government shutdown, the next deadline
Washington will have to contend with is at end of November when budget conferees are slated to
report on their progress. Why Congress has this maddening desire to draw lines in sand is beyond Greg.
If nothing happens, then they could delay their report until December 17. No one is talking about a
grand bargain. Conferees could come in with $110 billion in real cuts to end the sequester. They could
announce small changes in retirement entitlements including cola adjustments or means testing along
with a little in revenue increases. Carried interest may be on the table again. But, expect no big changes
in taxes for clients. No deal means another year of a falling deficit under the sequester. This trend of
declining spending will continue as long as Republicans hold the House.
As for 2014, a change in control is very unlikely even though the Democrats only need to pick up 17
seats in the House. This is a big number given the way districts drawn. The big albatross around
Democrats neck is Obamacare, which is another reason why it is unlikely that control will change in the
House. Republicans are likely to pick up three to four seats in the Senate, not enough to change control,
but enough to keep a lid on spending for the next two tree years
3. Lame Duck President
The third big theme from Washington is that we have an activist liberal president who is totally dead in
the water. Capitol Hill Democrats are most critical of Obama. Life boats running away from Obama’s
agenda are full. Greg has never seen a president become a lame duck so soon in his second term. He
became a lame duck in March 2013 when background check legislation failed in the wake of the Sandy
Hook Elementary School shootings. The only real danger remaining for the markets is from the Obama
administration’s regulatory policy.
Immigration reform is dead, and there is little chance of tax reform. Expect continued gridlock with
conservative fiscal policy firmly in place. The President is a spent force.
As for 2016, Hillary appears already anointed, but she has a big problem. Every eight years, the country
wants a significant change. With Obama’s approval rating in the latest poll at 39%, she has to
differentiate herself from him. Biden has the same problem. The only politician the Democrat base gets
excited about is Elizabeth Warren. Hillary’s crony capitalism is not exciting the base
On the Republican side, Rand Paul is the most popular among the base while the establishment is
rallying around Chris Christie. Christie would likely win in NJ and PA, gaining 34 electoral votes that the
Democrats usually get. Candidates who could bridge the gap between warring GOP factions include
Rubio, Ryan and Scott Walker. Tea party candidates are antipathetic toward Wall Street.
There is an emergence of a movement consisting of tea party fiscal conservatives, social issue
libertarians and isolationists. On the Syria debacle - had the President gone to Congress asking for a vote
on striking Syria, he would have lost by a 3 to 1 margin. Identifying the good guys in Syria was a big
factor. But, our war-weary nation may be moving toward taking on no more commitments in the Middle
East, which has negative implications. This reminds Greg of the isolationism in the 1930s.
The most powerful person in the world right now is Putin. Israel’s isolation has emboldened Iran. When
the French backed out of the negotiations on grounds that the U.S. was being too conciliatory, you know
Washington is trying too hard for a deal.
In summary, major themes coming from Washington are favorable for the stock market. Do not listen to
the hype and noise stirring people up.