Straight Talk: Market Grinding Higher but Can It Keep Bears At Bay?
May 11,2015
LIZ ANN SONDERS: Hi, everybody. Welcome to Straight Talk, an exclusive webcast from Charles Schwab. I'm Liz Ann Sonders, Chief Investment Strategist here at Schwab, and I want to thank you all of you for joining in.
[See Video]Well, we've had some volatility this year. We had a particularly weak first quarter, in terms of the economy in the United States. Earnings season has been, eh, relatively weak, not as bad as feared. But, really, what's amazing is how persistent investor skepticism has been, six-plus years into this bull market. And throughout all of this, all the skepticism, the market has been grinding higher and now is in positive territory for the year. So what are investors to make of all of this?
Well, joining me to talk about this market and where we are headed is Randy Frederick. Randy is Managing Director of Trading and Derivatives with the Schwab Center for Financial Research. He is one of the early architects of Schwab's options trading platforms and analytics tools. And, Randy, you and I talk regularly. We often speak together at events. And I love having you on the Straight Talk program. So it's great to have you on the program again. That's so much for joining me.
RANDY FREDERICK: It is my pleasure to be with you, Liz Ann.
LIZ ANN: So what we're going to do is start the way we normally do, which - I'll just give a few minutes of a macro update, and then I'll turn it over to Randy. We'll have a conversation. Maybe we'll try to start with some of the macro conditions in the economy, and then work that into some of the implications for the market, how it's behaving and some takeaways for investors.
So let me just start at the most macro level and talk about the global economy, and the context of a theme that we have had for quite some time, which is monetary policy divergence. So most viewers know that the Fed is --maybe 'imminently' is too strong a word--but probably this year is going to start raising interest rates for the time since 2007. We have quantitative easing, which ended last fall. So the path the Fed has been on is toward monetary policy normalization--very, very different among other global central banks, whether it's the European Central Bank, or the Bank of Japan, or even the Bank of China, People's Bank of China. You're talking about a tremendous amount of ease and liquidity additions coming from global central banks. So you have the Fed moving in one direction, basically pulling the punchbowl away, while the other global central bankers are actually adding to their punchbowls. So we don't really have a major global liquidity problem; it's just coming from different sources. And this is causing some interesting behaviors in terms of the markets, as well as the economy. You've seen a bias shift away from US stock market dominance, which was the case in the last couple of years, to a year this year so far, where non-US markets have, in general, outperformed the US market. And one of our themes has been that investors who take a globally diversified approach may not actually lament that decision this year, for the first time in several.
Now, as far as the implications for the US economy, as I mentioned when we started the program, the US economy had a very weak first quarter. It is important to note that this is a trend. For the last six years in this expansion that we've had so far, in the last 10 years, in the last 20 years there's been a very, very strong tendency for the first quarter to see incredibly weak growth before rebounding there. The consumer is in fairly healthy shape. We think that rebound is likely to come this time. Some of the culprits in the first quarter were the weakness in oil prices, the strength in the dollar and the implications that that has had for multinational earnings. And, as a result, we're seeing a weaker earnings growth picture. Now, valuations in the US are a little bit above median levels, which means the market may need to pause a bit for earnings to catch back up to those valuations, but many non-US markets have been performing a bit better. We've hit that inflection point, where things have stopped getting worse and started to improve, to some degree courtesy of what these central banks are doing.
So I want to leave it there for now, and we'll get into the market conversation in a little bit, but I want to start with the macro environment. And, in particular, Randy, have you share your thoughts on the economy, broadly, in the US, but maybe specifically some of the things that occurred in the first quarter to make it such a difficult quarter. And, of course, we've got some revisions coming, which are not set up, probably, to be very good. We may even see revisions take growth into negative territory. So why don't we start with the first quarter and just talk about the economy?
RANDY: So a couple of things you mentioned, I think, are really fascinating. One is, you talked about the volatility in the first quarter. I was looking at volatility. What's interesting about volatility is that investors oftentimes think of the VIX and being the only real gauge of volatility. From the perspective of the VIX, we haven't seen really high VIX levels this year at all, even in the first quarter. What we have seen are very big day-to-day swings. And one way to look at that is there's a chart study that technical traders use a lot called the Average True Range, which measures the day-to-day swings in the S&P 500 from a day-to-day basis, or really, any index. What I thought was fascinating was that in the month of January, despite the fact that it wasn't even as negative as we had in January of 2014, the day-to-day swings from the high to the lows and from day-to-day, were actually twice as big as they were in 2014, which is pretty fascinating. And even in the last couple of months as things have settled down just a little bit, we're still averaging about a 50% higher day-to-day swing, to the high to the low, than what we saw in 2014. That's pretty fascinating, especially when you go back to what you mentioned a moment ago about GDP. Yes, it is a trend that we've seen for a very long time, where Q1 has been weak, and then Q2 has gotten better, and Q3, and it typically gets better as the year goes on. But Q1 of this year, again, while it was negative, still not nearly as negative as what we saw last year. So I think that's probably part of the reason why people aren't quite as worried as they were last year, but certainly it does set us up for a very nice rebound, I think, in Q2.
LIZ ANN: And I think you make some good points about the difference between the VIX, the Volatility Index, and those moves in the market on a day-to-day basis, because, quite frankly, I'm not so sure a lot of our viewers and a lot of our investors obsessively focus on the VIX. They live the market on a day-to-day basis, so these percent moves, which you're right, we're getting back up to levels we haven't really seen since 2011, that's what infects the psyche of investors, and I think helps to explain why the angst we know we sense from investors is not reflected in a standard volatility measure like the VIX.
RANDY: Yeah, that's exactly right. But I think it creates this sort of disconnect to people that they don't understand. The VIX has been around for a very long time and most people think of it as sort of the proxy for market volatility, but the VIX is driven by institutional traders who are hedging the downside to the market. So when the VIX isn't high that doesn't mean we can't have very large day-to-day swings. It simple means that the institutions that typically drive the calculations the drive the VIX are not protecting the big downside in a big way, but day-to-day swings can be very, very unsettling for investors, which is something I think that they've experienced, and it's that disconnect that I don't think people fully understand sometimes.
[See Video]LIZ ANN: You know, you mentioned the word 'disconnect.' And I want to switch gears here and talk about what is often perceived to be a disconnect between how the economy is behaving--and this is not just a US conversation; this could be applied to any market--how the economy is behaving and how the markets behave. So a lot of people have wondered, 'Well, the US is still the global growth engine, we still have decent growth, notwithstanding the weak first quarter, but decent growth, certainly relative to much of Europe. Yet we've got a US market lagging some global markets right now, in particular, you know, China's stock market, which, clearly, growth is slowing there. So maybe talk from your perspective as a day-to-day, more short-term market water about the dynamics between what's going on in the economy, maybe the concept of inflection points, and what can often happen in the market, and cause some frustration for investors thinking, 'I don't get it,' where the market behavior doesn't seem to be matching economic behavior.
RANDY: So I think there's two key points there. The first one is, and I know you've mentioned this many, many times, as have I, the markets are very much a forward-looking mechanism, and the market has a tendency to run anywhere from 6- to possibly as far as 18 months ahead of the economy. Usually, it's around 6- to 12 months. So that's the first point. So when people want to get an idea for where the economy might be heading, a lot of times looking at the market is a good way to do that, and it is often, again, another disconnect between, 'Well, the market is doing extremely well, but the economy doesn't look all that good.' Well, that's because the markets are looking forward to what we can expect going forward.
And the second thing, I think, is comparing what's going on in the US economy relative to other economies around the world, which goes back to what you were mentioning earlier. We are in the process of getting to interest rate normalization, whereas the rest of the world is still in an accommodating area, where they're cutting interest rates and they're creating quantitative easing programs, and things like that. So the US economy is way ahead of the rest of them, which is part of the reason why there are some opportunities, I think, in other parts of the world, because, in some sense, in Europe, for example, is maybe where the United States was at three or four years ago. We've already had a market that's performed extremely well, it's up well over 200% since the bottom we reached in March of 2009, whereas Europe, which is now still in sort of, I guess you could call it almost the heart of their quantitative easing program, has not performed as well over such a long period of time, and they may have a lot of upside to go, whereas our markets seem to be at a point where, 'Yeah, we hit a new high just a few days ago on April the 24th, but it took us several attempts to break through those levels before we finally did. And that high only lasted a single day, and then we've come down.
So it does feel very much like, from the perspective of the S&P 500, that there's an enormous amount of resistance there right around that 2,100 to 2,120 range, that, as you mentioned, with valuations as high as they are right now, and as far as we've come, it's going to be very difficult. We've got to have something change in order for us to break through that level. Whereas, in other parts of the world, we have, I think, all sorts of upside still available because they're still very accommodative.
So that's sort of that disconnect between what's going on here and what's going on in most of the rest of the world.
LIZ ANN: Yeah, and, you know, you talked about potential catalysts, where the market needs some sort of juice. And, you know, in the US market, actually, what's interesting about what... earnings, which have been relatively weak, and I touched on when I opened the program here, is not quite as weak as what analysts were expecting coming into the beginning of the quarter. In fact, I think we're getting close to a record improvement in growth expectations. So, obviously, as you start earning season, there's an expectation for what earnings growth will be, and then you start to get numbers that come out, and you see changes based on the fact that, okay, we've already got some actually numbers in, so it becomes easier to estimate when you've got a subset of actual reports. And it's interesting, coming into the first quarter, expectations were for a drop for S&P earnings in the first quarter of more than 5-1/2%, and now we're back up into positive territory. So there's one short-term potential positive catalyst is that this expectation that we were heading into not an economic recession but an earnings recession, that may be postponed a little bit. Expectations are still negative for the second quarter, but they've actually moved back into positive territory. So do you think maybe that's been one of the reasons why the market has been somewhat resilient in the last couple of weeks?
RANDY: I absolutely think that's true, yes. And, in fact, throughout almost the entirety of the first quarter we saw expectations for earnings coming down until about the last two- to three weeks before earnings season started, which, of course, is a couple of weeks after the quarter ends. At that point, we finally started to see the earnings pick up a little bit, but it was a little bit too late. And I think there's two reasons for that. One is that, obviously, the strength in the dollar is having a huge impact on companies that do a lot of exporting, so that's typically manufacturing companies and very big well established companies, as opposed to smaller companies and companies that are more in the services sector. And, secondly, everyone sort of knows that how well a company does - what's most important is not what it earns, but it's what it earns relative to what the expectations were. So I think because of the weakness in the energy sector, which everyone expected and weakness in the export business, the bar got lowered for virtually everyone. And part of my commentary throughout most of Q1 was to keep your eye on all the companies that either aren't in the energy sector and aren't big exporters, because the bar has probably been lowered a little bit too low. And I think the number of companies that have beat, especially on earnings, not necessarily on revenues but on earnings, has been pretty substantial this quarter relative to previous quarters, and part of the reason for that is simply because that bar got a little bit too lowered for all of these other companies that are not in those two sectors.
[See Video]LIZ ANN: And I think that is an extremely important point, is this concept of the expectations bar. And I think this is another thing that could sometimes trip up investors, is they often think of things and measure things comparatively, whether it's one economy versus another or one company versus another, using absolute measures, as opposed that sort of, you know, relative to expectations...
RANDY: Relative measures.
LIZ ANN: And it's... right. And it's one of the reasons why one of the popular set of broad economic indicators that tends to drives markets to a significant degree in the short-term are these CitiGroup Economic Surprise Indices, which very popular in the United States, but Citi applies them to a number of other regions and countries. And they are just that, they are measuring whether economic indicators are coming out better or worse than expectations. So I recently did a client event, where I showed the US Economic Surprise Index compared to the European Economic Surprise Index, and people were surprised that the one for the Eurozone was quite a bit higher than for the US. And I had a hand raised, saying, 'I don't understand. US growth is much stronger than European growth. How could that index be higher?' And I pointed out it's a surprise index. And in the case of Europe, to your point, it may be that the expectations bar got set so low that you had the ability to outperform those expectations than when an expectation bar is too high. And that, really, is what defines important moves in the market, less about that absolute level of either growth or earnings, etc.
RANDY: Yeah, I think that's a very good point, and I think that's where sometimes people also have this disconnect where if they continue to see earnings expectations rising throughout the quarter they get very, very optimistic that it's going to be a wonderful quarter, and that when earnings come out that the markets are going to skyrocket. What they don't realize is that that continual rise of earnings expectations is essentially building in the market rise. And, typically, the market will be rising as that's happening, and then once the earnings come out, even if they're stellar relative to Q1--and I think we very well could see an improvement in earnings in Q2 versus Q1--oftentimes the market will falter, and, again, people don't quite understand that. But as you say, it's the relative difference that's the most important piece.
LIZ ANN: Right. You know, we've touched on the strength in the dollar and the impact that that has on the export side of our economy and multinationals, but also the decline in oil prices, and ostensibly the benefit that should accrue to the consumer side of the economy. So talk a little bit about that. Our economy needs consumer spending, because not only are other areas not terribly strong, but consumer spending drives 68% of real GDP in the US, but retail sales have not been stellar. So what do you think... again, maybe we have this theme developing here of disconnect between what should have been a nice kind of tailwind behind the consumer and what has actually been happening?
RANDY: Yeah, and we've seen a change in that just very recently. We had three consecutive months of disappointing retail sales, but the very last report we got did show a little bit of pickup, not quite as much as what people were expecting, but it definitely was a positive. But I think these are very good points, and I know I've said it and I think many of us have said many times that lower oil prices, in general, are positive for the economy because it does free up money that consumers can use to spend on other things, which it's shopping or going to restaurants, or whatever that might be. But what we had was such a very dramatic decline in oil prices from about the middle the 2014 through the end of 2014, that it became very, very disruptive. Not only did it disrupt people because it was so sharp, but it also causes enormous havoc throughout the oil industry. In fact, by just last month, I mentioned a couple of times in some of my commentary that we've had more than 100,000 jobs announced to be laid-off since the beginning of December through about the end of April in the energy sector. But I think, now, we've seen a pretty good rebound in oil prices here in the last few months to the point where we may be at a point where oil prices are in sort of what you would call maybe a goldilocks or a sweet spot, where the prices have come back up enough to where some of the higher-cost producers may very well be at a point where they can continue to turn a profit, or at the very least, stop cutting jobs and stop turning off the lower-producing rigs. But at the same time, oil prices on a year-over-year basis are still much lower than they were. Yes, they've come up about 30% since the beginning of this year, but they are still way lower than they were about a year ago, and so, therefore, we still have available money for consumers to go and spend.
Consumers are notoriously cautious when it comes to spending because forever oil prices go up and down, up and down, and people expect that. And anytime prices get cheap, they kind of know that, 'Well, we better not go out and spend a lot of money because next month oil prices are going to come back up.' This time they've stayed low for about nine months before they started to come back up. So, yes, they have come back up, but if they level-off a bit, we can save some of the jobs in the energy sector, we can keep those companies in that group profitable, but at the same time, we do have more available money for consumers to spend. And, as you said, since they drive about two-thirds of the economy, consumers will probably, at some point, get comfortable with this, that oil prices aren't going back up that sharply and gas prices are going to stay at least at a comfortable level and they will start spending. And I do think, as I mentioned, the very last retail report we got was a positive report move for the first in four months, and I think that may very well be a trend that we'll see throughout at least the next quarter or so, that we will see stronger consumer spending and that will drive the market a little bit higher, and the economy, as well.
LIZ ANN: I agree with you. I think consumers need to get a sense there is some... maybe not lifelong permanence to lower prices, but that it's not just a short-lived situation. But I also think, though, that's what unique about this period right now is that we are in a kind of post-debt super cycle environment right now. Now, the private sector has deleveraged to a significant degree since the financial crisis in 2008, and most traditional ways of measuring debt, you know, household debt as a percentage of disposable personal income are well through the normal trend line. But don't you think, also, though, that consumers, and even investors, to some degree, their mentality has changed a bit? We've come through, really, two epic periods, both of which included more than 50% drops in the stock market, and then in the case of the beginning of the problem in 2000, you had a bubble burst in the case of tech stocks, and then, of course, you had the housing bubble burst. So I just wonder whether this change in psychology is something that is going to be with us for some time. We're not going to see the consumer kind of launch into sort of this debt-fueled spending mode that really drove the economy prior to the last couple of cycles.
[See Video]RANDY: I think that's very true. But there is, also, the other side of the coin, and that is, that, yes, consumers, I think, are paying down debt, which is not necessarily a bad thing, certainly not for consumers. It may not be the best thing for the economy, but it's definitely good for consumers to probably carry a little bit less debt. And they're even, in fact, putting some of their money into savings, which, again, is also a pretty good thing. But at some point, the debt gets paid down, the savings accounts get filled up, and then, all of a sudden, if you still have expendable income, you have to go out and start spending, which I think we're right at that cusp where that's about to start happening. But I do think you're right, in terms of sort of a general broader, longer-term change of psychology, which is not necessarily a bad thing. I know you've mentioned in some of your commentary recently about the number of people that actually own credit cards has continued to trend lower, especially for some of the younger people in our population, which I think, again, is not necessarily a bad thing. But I think we would have to go through a very long market cycle where we have a much more moderate bear market, rather than, as you mentioned, these dramatic, huge selloffs of 50% or more, where it's incredibly disruptive, and, frankly, some people get scared completely out of the market and never come back.
If we could have a more modest 20-, 25 percent bear market that is a little bit less abrupt, then I think people will be comfortable with the idea that long-term equity investing is a good idea. But, as you said, these younger... the Millennials, and even some of the Baby Boomers... or the next group after them have followed... have been almost throughout their entire life have only seen these major meltdowns that have huge impacts on their families. And we've just got to get to a point where we moderate some of this stuff before people, I think, will start taking on this personal debt to the levels that they have in the past.
LIZ ANN: You know, and another reason, I think, for this skepticism, for this malaise that has been more persistent than either the economic or market numbers would suggest is that although probably the most common metric behind job growth, the unemployment rate, is down now to a pretty healthy level, 5-1/2%, there are other aspects to the jobs market that continue to sort of plague psyche and have meant problem with long-term versus short-term unemployment, and people who are working in part-time jobs that would rather be working in full-time jobs. And it's important for several reasons: One, because we know it's a big driver of consumer business confidence, of course, it's a big driver of the economy, but maybe just as importantly is that what makes the Fed unique among every other global central bank is that it has two mandates. There's two things the Fed is supposed to pay attention to when making decisions on monetary policy, and that is the jobs market and also inflation. So I want to talk to you about inflation in a minute, but give me your thoughts on jobs, because it not only, again, impacts the economy, but it's crucial right now, given that we're potentially at an inflection point from a Fed policy perspective.
RANDY: So I think there are three things that I pay a lot of attention to in the job market. As you mentioned, the unemployment rate at 5-1/2% is a very good level. Probably somewhere close to 5% we might consider full employment. Certainly, we were below that before the meltdown that began in '07, but in some sense we probably should never have been that low, because a lot of people were employed in the building of houses that no one wanted, frankly, or no one could afford. So we'll probably not quite get down to that level again before we reach full employment, but we are getting close to it.
But there's another number that I know you and I both look at a lot, and that's the labor participation rate. This is at a low trend... this is a line that's been trending lower and lower and lower, and, frankly, right at the moment, we're at like a 35-year low on this. Now, some of that is demographic because of retirements in the Baby Boomers. Some of it is because of a reversal of a long-term trend of working mothers has been reversing back the other way. It certainly won't get back to where it once was, but that has been trending. Some of it also has to do with people going to college or going to grad school to get more education, whereas in the past they might have gone out into the workforce. But some of it is real, and I think that is a very, very important point.
From a shorter-term perspective, what I'm looking at, typically, one thing that has looked extremely well for a very long time is the weekly jobless claims number. In fact, unemployment, as you know, is more of a lagging indicator, whereas weekly claims tend to be more of a leading indicator, and just last week, I know it was a single week, but the number that we got for the weekly jobless claims was a 15-year low, and the four-week moving average, which is sort of the more smooth number that people look at is just a couple thousand jobs above a 15-year low. So from the perspective of weekly jobless claims, all of these layoffs that we talked about earlier in the energy sector have never really shown up. There's only a couple of good explanations that I can come up for that. One is that either those layoffs never really occurred, or that other companies are either cutting layoffs or hiring fast enough to completely neutralize what we're seeing in the energy sector. So from the perspective of the leading indicator looking forward, the jobless claims number, the weekly jobless claims numbers look very, very solid, and then eventually that will start to spill over into the unemployment rate. So we very well will probably continue to see a downtrend in the unemployment rate here going forward.
LIZ ANN: Now, keeping in mind, though, that jobs is a piece of it that the Fed looks at, but one of the reasons why they have both a jobs and an inflation mandate is that eventually when job growth becomes healthy enough it tends to translate into a pickup in wages, which, in turn, feeds into inflation. So there's a connection between the two. They're not these two distinct mandates that the Fed has to operate with. And that, I think, has probably, the wage piece has been the thing that has given the Fed cover to say as, to use a word they no longer have in their statement, 'patient' as they have, and the fact that they've gone six-plus years now at zero percent interest rates. Now, the common measure of wages that we generally look at is average hourly earnings, and you get that in conjunction with the monthly jobs report, and that has continued to show relatively weak wage growth. However, there's a couple of other leading indicators, like the Employment Cost Index, that are starting to accelerate to a degree that maybe we're finally getting that first pickup in wage growth that would eventually translate into inflation. So I know you probably look at some of the wage data, but are you also starting to see some of those leading indicators suggest, boy, we may be finally seeing some traction there?
RANDY: Yeah, and I think that's an important point. The Employment Cost Index, which we got last week, was up for the first time. So it may be one of the very earliest indications that we have finally a little bit of wage inflation, and Unit Labor Costs are another one, and, as you mentioned, the Average Hourly Earnings, which we'll get on Friday on this week--those are all indications that we're finally starting to see a little bit of wage inflation, and we're just starting to see that. But I think the Unit Labor Cost is an important one, and the ECI, as we mentioned a moment ago, the Employment Cost Index. So, hopefully, we will see that trend continue when we get the average hourly earnings number this Friday. But I think part of the reason we've seen a little bit of softness in the market here in just about the last week, is that because that was one of the first few indications that we had that we might have a little bit of inflation. And, as you said, from the perspective of the labor market, the Fed is fairly comfortable, I think, with where things are. It's only the inflation side of their dual mandate that they're struggling with. And we've only seen just a tiny little bit of inflation from the perspective of things like the Consumer Price Index, and some of the other consumer inflation gauges have really only just barely ticket up. But the wage inflation numbers are just now starting to show some positive trend, so, hopefully, we'll continue to see that.
But that this going to cause the market to get a little bit concerned, because then that brings the prospect of a potential interest rate hike, which everyone is anticipating either June or September, potentially, makes it much more of a reality. And that may cause the market to continue to be a little bit volatile, which is what I think we're all expecting here over the next few months.
LIZ ANN: And not only that, you know, when you and I, because we tend to be equity-biased people, talk about the market, we're talking about the stock market. But it's also important for investors to look at what's going on in the bond market, and with the pickup in the 10-year treasury yield, that... first of all, I think it's probably sending a couple of messages. One, that the weakness in the first quarter, in terms of the overall economy, is going to be limited to the first quarter, and somewhat transitory in terms of its impact, but it may also be reflecting a pickup in inflation expectations, and the fact that global yields have turned back up from extraordinarily low levels, in many cases, negative yields. So, you know, I know both of us focus a little bit more in the equity market, but from your more trader's perspective, what do you make of this recent pickup, again, in long-term interest rates?
[See Video]RANDY: Well, I think it's exactly what you just said. If you watch what happens with interest rates--and I pay most attention to the 10-year bond interest rate--as we approach the dates that the FOMC has its regular policy meetings, you'll oftentimes see interest rates creep up. And they shot up very sharply before the March meeting. We saw that happen right before the last meeting, as well. But, now, we're a ways away before the next meeting, and yet we see interest rates coming up again. There's almost, I think, no question that that is the market's sort of perspective of the potential for higher inflation, which I think, again, we've talked about some of the gauges are starting to show a little bit of that, and I think probably on Friday of this week we will see that again when we see the Average Hourly Earnings numbers. And if interest rates continue to move higher, it's in anticipation of that first Fed rate hike. And, you know, in the past, we've seen it run up into the Fed meeting, but then after the Fed meeting, if they come out with somewhat of a dovish tone, which they've had, then the interest rates will come back down. But I got a feeling now that because we're running up and we're well ahead of the next meeting, we may not see that happen in the near-term. The interest rates may stay where they're at until we get to the next meeting. So, yeah, I do definitely think that that is sort of an early look at the sort of an anticipation of higher inflation going forward.
LIZ ANN: And I don't think any of us at Schwab think that we've got an inflation problem brewing, but what's interesting to me, and I'll ask you for your same perspective, because you and I both spend a tremendous amount of time on the road talking to our clients, investors, and I would say in the first couple of years coming out of the financial crisis, in the beginning of all of this extreme monetary policy loosening on the part of the Fed, starting with just taking interest rates to zero, and then first and second and into third round of quantitative easing, there was this almost paranoia about inflation, that with the Fed pumping all this money into the system, printing money, whatever terms you wanted to use, that this was an inflation accident waiting to happen. And, of course, it wasn't because that money that the Fed was pumping into the financial system would only cause inflation if it was coming out via lending going into the economy and picking up velocity, which is why it's called the 'velocity of money,' which hasn't been the case. I don't know, you and I, I think, are both contrarians. I cannot remember the last time I got a question or a comment from somebody that expressed any concern whatsoever about inflation. So I'm known as saying I'm always less interested in the story everyone is telling and more interested in the story no one is telling. And I can't help but think, given that it appears inflation is not on anybody's radar anymore, maybe we ought to at least have it on our radar screen.
RANDY: Yeah, I do occasionally get questions about inflation, but it's more because of a misunderstanding of the way the Fed measures core inflation. I hear people say all the time, 'Well, college costs are going to the moon. And until middle of last year, gas prices continue to go up, and every time I go to the grocery store it costs me more. How in the world can you say there's no inflation?' And then you kind of have to explain, the difference between the core inflation measure that the Fed is keeping an eye on versus overall inflation. But, yes, there are certainly pockets of the economy where prices continue to go up and up and up, there's no question about that. But that's usually the questions that I get. But you're certainly right, during the early phases of this I think a lot of people were scared to death about all of the... as you said, the Fed printing money, and how that was going to create inflation like crazy. And part of that, I think, is that a lot of people were on television everyday telling them that that was what was going to happen. But there are other ways to look at this.
If you think about it, and it's not just the velocity of money that you're talking about, but imagine, if we were printing money, if the Fed is printing money and they're making money very easy to get, and even if it was getting out there into the economy, there's no way to make that money available, that easy money available only to the consumer, without also making it available to the producer. So imagine if the creation of easy money makes it just as easy for companies to acquire that money at a very low cost, to produce a whole lot more of whatever it is that they produce, which creates an over-supply, which, in some sense, would just simply cancel-out the increase in demand that might be created on the consumer side. So while I think the whole goal of the money printing, if you will, or the easy policy is to create consumer demand and create inflation, you can't really do that all that easily without also creating increases in production and supply, which then cancels that out. And I think that's part of the reason why we have not seen inflation like people expected, and... and, in anything, really, inflation, for the most part, over about the last year has just been going sideways because the two are kind of neutralizing, the demand side and the supply side.
[See Video]LIZ ANN: Although, let's talk about another factor here that's come into play really this entire bull market, which is thanks to low interest rates, you're right, companies have been taking advantage of low borrowing rates, but they've also taken a big chunk of what they've borrowed and put it back into their own companies via stock buybacks. And I often get the question, all right, if it's not the retail investor that's been the big driver of this bull market, it's actually not been hedge fund, pension funds, actually, have... traditional pension funds have more fixed income exposure than equity exposure now, so where has the juice been under this market? And the answer really is the biggest marginal buyer has been the companies, themselves. So I know that's something you look at. What do you see as sort of trends going forward in that desire and interest in US companies buying back their own stock?
RANDY: I think that's a very, very good point, and I believe you're right. I certainly think that as companies find it very, very cheap to get money so they could sell bonds at extremely low interest rates, they can get cash easy, and so they use that money to buy back their own shares, which reduces the total number of shares outstanding. And for revenues that are either unchanged or in some cases even lower, they can actually boost earnings per share. So that's part of the reason why I think on a quarter-over-quarter basis we continue to see the number of companies either meeting or exceeding their earnings per share targets have been, you know, somewhere between two-thirds, and then this quarter somewhere close to three-quarters of all the companies, whereas the revenue numbers have really not been improving all that much. So that is a bit of a concern, but it also... there's another side to that coin, as well. I you're a pessimist you might say, 'Well, if companies are continuing to buy back their own shares, which makes their earnings look better, but their revenues are not growing, well, that's nothing more than financial engineering. That's a big problem.' But at the same time, you could also say, 'Yeah, but since these companies are sitting on boatloads of cash, they're actually in really good financial shape, and they have the flexibility to keep their earnings looking good, to continue to be very profitable from a company's perspective without laying people off, without cutting... without doing things that have a negative impact on employment and other things.' So you can look at it as an optimist or a pessimist.
Eventually, sure, there's a point where you can no longer just keep buying your shares, you can no longer just continue to cut costs. Eventually, you have to grow your revenues. But if you could use these tools during times like Q1, for example, when we are in a soft patch of earnings to hold you over until you get to the point where you start growing again, which is what we hopefully will see here in Q2 and going forward, now that's good that they have that sort of flexibility. If companies are very heavily leveraged and the cost of that leverage because of high interest rates is making it very difficult for them, they can't do that, then all of a sudden, you start to see falling, not only revenues, but also earnings. These companies have a lot of flexibility because they have all this cash on hand, and that allows them to sustain these soft patches that we've been going through.
LIZ ANN: Yeah, and, you know, we've had a positive view on the cap ex cycle, due, in large part, to the mountain of cash that companies are sitting on, not to mention the fact that companies haven't been investing to the same degree they have in the past. We have an age problem in terms of fixed assets already, post-World War II record high. And then, interestingly, very recently, you've got some very, very well-known iconic-type investors who have come out somewhat publicly and said, 'Enough with the short-term-ism.' And, you know, we, at Schwab, we try to focus on that quite a bit with our investors, making sure they take a reasonably long time horizon to thinking about their investments over the long-term, aside from what they might do on a short-term trading basis. And I think it's interesting that some of these iconic investors are now suggesting to companies that they need to think longer-term, and not just for the benefit of quarter-over-quarter earnings gain. So it will be interesting to see if that has any traction in taking some of this cash mountain and seeing it devoted to longer-term capital spending, longer-term hiring.
RANDY: Yeah, I think that's a very, very tough nut to crack. As long as we have a climate where companies are required to report their earnings on a quarterly basis, and their primary objective, really, for every company is to be profitable so that they can maximize shareholder value. I think it's going to be very, very difficult for most companies to focus on, say, annual goals, as opposed to quarterly goals. And, if anything, and you know this as well as I do, we've been in the industry for a very, very long time, investor time horizons continue to get shorter and shorter and shorter. So on one hand, you've got companies who would maybe like to focus on longer-term goals and not be so focused on quarter-over-quarter results, but at the same time, you've got shareholders who I think are not necessarily these big iconic... these big iconic institutional investors that you're talking about, but your typical retail investors who are sort of demanding that they continue to perform on a quarter-over-quarter basis. So the two are sort of at odds with each other. And I don't know how it's all going to come out, but I think as long as we require companies to report on a quarterly basis, it's going to be very, very difficult to sort of change that. It may take a whole generation, I think, and really everyone onboard before we can make that change, if it happens at all. I'm just not so sure that it will.
LIZ ANN: So, you know, speaking of corporate earnings, one of the things that we talked about when we were getting ready for this broadcast here were catalysts. And, you know, it's always possible to layout some positive catalyst, some potential negative catalysts. And one of the catalysts we talk about possibly for the upside would be if, indeed, the earnings bar had gotten set too low, so we've already touched on that. But maybe share with me kind of off the cuff, what you think are a couple of both upside potential catalysts, but also catalysts that could potentially roil the market and maybe bring, possibly, the first correction in several years?
RANDY: Well, let's talk about the negative first, because it's always better to talk about bad news then the good news.
LIZ ANN: Yeah, good.
RANDY: I think the negatives that we see out there are kind of the same negatives we've been seeing for years. And probably one of the biggest ones, and this one has been going on for three- to four years now, is the situation in Greece. And it's interesting because, as you know, in the fall of 2011, the Greece situation really scared the market. The S&P 500 pulled back almost 20%. But I think as time goes on, the situation in Greece, while it hasn't been resolved by any stretch, I think people are starting to realize that it's maybe not as big as people thought it might be. There's always concern that if Greece defaults of if Greece leaves the Eurozone that it could spill over into Portugal and Spain, and maybe even Italy, and that could be a major problem. But, as you know, I live in Austin, Texas, and when I talk to clients, a lot of times I mention that the economy of Greece is about the size of the city of Dallas, Texas. Now, Dallas is a big, important city, but certainly from the scale of the United States it's not that critical. And I think when you compare Greece to Europe, as a whole, you get an idea of how really... I don't mean to say insignificant, but how small it is. And I think the markets are finally starting to accept that because as the day-to-day news sort of ebbs and flows about Greece, our markets have taken that a lot more in stride than it did a few years ago. So I think that's a negative.
The other negative, of course, we've talked about is the fact that companies are using, if you will, financial engineering have continued to meet the earnings targets, but the revenues haven't been growing.
[See Video]So on the positive side what are some of the potentials, I think, that could push this market higher? Well, if we could actually see true revenue growth in corporates, rather than in just earnings per share. And I think we may be right on the cusp where we start to see that.
There are a couple of other things that we've talked about earlier, such as the strength in the dollar. I'm encouraged by the fact that we've seen the dollar level off a bit versus other currencies, as opposed to continuing to climb higher which was causing a little bit of volatility, I think, in January and in March of this year. And then there's energy prices. Again, we saw energy prices bottom-out about six or eight weeks ago. We've now seen a pretty good rebound in energy prices to the point where, again, maybe the companies in the energy sector are going to stabilize a little bit.
So all of these are potential catalysts, I think, that could potentially push the markets higher. And then if we get the consumer onboard, a we talked about earlier, where they get comfortable with the fact that the dollar is stable, that oil prices are stable, they filled up their savings account, they've paid off their credit cards, and they're ready to go out and start spending, I think that can all drive not only the economy, but, also, the markets higher.
But, at the moment, in the meantime, I think the markets are little bit limited to the upside until we start to see some of these positive catalysts come in, and the S&P 500 in sort of that 2,100... or 2,000 to 2,100 range is somewhat limited to the upside until we see some of these developments come into play.
LIZ ANN: So I'm going to go back to the risks, not to bring up the bad news side of the story, because I happen to agree with you. But one of the risks--and I believe it's because you don't think it's a risk--that you didn't mention is one that a lot of market bears often point to these days, which is that we're in another bubble. And I think that that concern was heightened when the NASDAQ crossed its all-time high from the year 2000 and went to, you know, comfortably above 5,000. So we've talked about this, but share with our audience here why you think a NASDAQ... the word 'bubble' is not the appropriate term to apply to the NASDAQ, or really any other bubbles that you think are out there?
RANDY: That's a great topic, and I think it's really interesting, and I've written about it a few times recently is that a bubble is one of those things that you don't really know you're in a bubble until after it pops. And, oftentimes, you will see sharp run-ups in many, many things, and then if it then moderates and comes down slowly we wouldn't call it a bubble. It's only a bubble if it falls sharply. And so there's no way to really know if you're in a bubble until after it happens.
But I think with... specifically talking to the NASDAQ, there are two key elements, I think, to the NASDAQ crossing into a new record high that are critical. And the first one is that when that happened back in the spring of 2000, it took only 18 months for the NASDAQ to run up from about 1,800 to about 5,000, so a very, very sharp run-up. This time it took six years for the NASDAQ to cover essentially the exact same ground. That's an important distinction. The second one is that the price-to-earnings ratio was over 100 at the time the NASDAQ hit that level back in 2000. Now, it's something like 24. So that means that the companies that are driving the NASDAQ higher this time, not only are they getting there in a much slower fashion, but they're getting there through the traditional means, which is they're growing the companies, the revenues are growing, the earnings are growing, and there's legitimate earnings, in fact, behind that growth, rather than just speculation and forward-looking to what might be. So those are two very, very, I think, big distinctions, is the actual earnings and the amount of time that it took to get there.
So, other than that, the only other comparison is just the fact that they're both at the same level. But if it got there through a different means, I, by no means, would see this as a bubble. Does that mean that we might not have a pullback in the NASDAQ? No, not at all, but the kind of meltdown that we saw throughout the middle and latter parts of the year 2000, I just can't imagine that that's going to happen. That's just my perspective, but given the differences between the two, that's what I would expect.
LIZ ANN: Oh, no, I completely agree with you. I think the other thing to point out is that we have to take inflation into consideration, too. And if you were to get to an all-time high in the NASDAQ on an inflation-adjusted basis, you're talking about over 7,000. So we can't look at things in an absolute sense. We have to look at them in an inflation-adjusted sense, and the fact that that index is more diversified than it was back in 2000. I think it was 77% of the NASDAQ was tech stocks back in 2000, and it's about 44% right now. So I agree.
I think there's this... almost a paranoia by investors to make sure that they don't miss the next bubble. It goes back to what we talked about earlier, this persistent pessimism and skepticism, and sort of looking around the corner for the next crisis, the next bubble. It has everybody so on guard even six-plus years into this, which tells me that the so-called wall of worry that the market likes to climb is still intact. Do you agree?
[See Video]RANDY: I absolutely agree. And, as you mentioned, we both have somewhat of a contrarian bent, and I think that that's a very good thing. There's been pessimism throughout the entire six years of this bull market, and it continues to be there. When we hit these major thresholds, such as the NASDAQ hitting a record high for the first time since the year 2000, when we see the S&P 500 hitting something like 40 or more records last year, and a couple this year, the most recent of which I mentioned earlier was just back on the 24th of April, we don't see the kinds of celebrations, and champagne corks popping, and streamers flying that we saw back in the past when we've seen these, which means there's an enormous amount of skepticism still out there, which means there's still money on the sideline that hasn't necessarily come in. And, again, the old saying, we hate to say it because it's very cliche, the market climbs a wall of worry, and there certainly is plenty of worry still out there.
LIZ ANN: Yeah, absolutely. So let me wrap up there. So I think Randy and I are generally in agreement. I've been long on record as believing that what we're in here is what's considered a secular bull market, a long-term bull market. But that doesn't mean you don't go through periods where the market can pull back, where you go through corrective phases. They're actually very healthy, and, in fact, they help to elongate secular bull markets. So even if we were to get one, I don't think it's likely to be the type of calamity we saw in either 2008 or 2000.
So, Randy, as usual, when we talk there is so much ground to cover. I think we got through a lot today. It was lot of fun. So I want to thank you for spending time with me and, of course, all our viewers.
[See Video]RANDY: It was absolutely my pleasure. It's always fun to talk about this.
LIZ ANN: And speaking of our viewers, thanks to you for joining us. As always, if you have any additional questions, whether it's on today's topic and video, or any specific questions about your portfolio, as always, you can talk with one of our financial professionals at Schwab. And if you have an interest in more research, we have a great online resource within the Insights tab on Schwab.com. That's where you can find my latest market commentary, as well as information and commentary from all of the Schwab experts on a wide variety of topics. Now, Randy speaks about and also writes on a wide variety of trading topics, and the easiest way to find his articles is to just type his name into the search box on Schwab.com before you log-in.
But, again, we are so thrilled you took the time to tune in. We look forward to continuing these programs for you, talking to you again soon. We really do appreciate your time and attention. Thanks so much, and have a great day.
