Most investors are oblivious to the risk(s) posed by a deterioration in the U.S. economy and flow-through to corporate earnings.
This new in-depth discussion between macro powerhouses Liz Ann Sonders (Chief Investment Strategist, Charles Schwab) and Hedgeye CEO Keith McCullough dives deep into this development and more.
Here’s a key takeaway from Liz Ann Sonders:
“What keeps me up at night—I do worry about a bigger crack in the low end of the investment grade spectrum. When you think about the analogy of ‘When the liquidity tide comes out, you know who's swimming naked’ or ‘You throw a stick of dynamite in the water and the minnows come up first and then the whales later.’ You always have to wonder whether there are some naked swimmers out there. I think heading into the next recession, it's more likely to be garden variety than an epic 2007 to 2009.”
We transcribed key excerpts from this conversation between Keith and Liz Ann below.
Click here to watch the entire conversation.
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Keith McCullough: Welcome back to the Hedgeye Investing Summit with the one and only Liz Ann Sonders. We're going to get right into it.
Let's start with FOMO.
On the institutional side, you have career risk management that I can clearly see in my inbox. At the end of September last year, and at the end of July of this year, clearly people are sitting there saying, ‘Oh my God, I’ve got to get out of those bond proxies and into growth.’
I have a hard time rationalizing that pivot, buying into a big deceleration of negative year-over-year earnings. You guys have done a bunch of work on it. How do you look at the cycles historically when you're about to go from, from peak earnings to it's still good to what we think that could be down -5% to -8% year over year S&P earnings? Do you want to buy into that or during that?
Liz Ann Sonders: Not only have to have some confidence in the forward look to earnings, which I think is particularly tricky in this environment because although, as you know, I don't look at individual stocks, I don't analyze individual stocks. I don't tend to speak individually to the analyst community. But I'm broadly aware. There's very little sense that any adjustments to 2020 have been made specific to the trade war.
All of us are sort of sitting in waiting mode to get a sense of whether the December 15th tariffs kick in. Because of the bias toward a more consumer-oriented goods that's important in terms of the outlook.
The second part of my answer is you have to have an assessment of the macro environment too. I think the last two years have been interesting with regard to earnings. It's not just the trajectory of earnings because 2018 was obviously a great year for the “E” part of the equation. But multiples were under compression the entire time because the Fed was tightening and financial conditions were tightening so that put downward pressure on multiples.
That’s a complete mirror image of 2019. You lost virtually all the “E” but you've had upward multiple compression because the macro environment changed and you’ve looser monetary policy and looser financial conditions. So I'd need to know not only the trajectory of earnings looking into 2020 specific to the trade war, et cetera, but also what do the financial conditions look like?
McCullough: The rates of change of those financial conditions drive the earnings too.
Sonders: I think we've gotten as much multiple expansion off the back of macro conditions or we're going to get. I've been calling this environment we’re in “moments of truth.” I think we're going to get some answers to a lot of these burning questions. Given that macro does not support much more multiple expansion and the “E” has to start doing more of the heavy lifting, what does that actually look like in 2020?
For now, we've had this bifurcation between the manufacturing recession and services or consumer hanging in there. We're starting to see some cracks in that dividing line as is typically the case through the employment channels.
I think we'll get a better sense of sense of that. We saw the crack in ISM Services Employment. So I think whether it's trade or bifurcation or earnings, we're gonna get some answers that I think help clarify some of the lessons.
McCullough: That's interesting. So in four to six weeks we're really going to see the whites of the eyes on this?
Sonders: I think trade, Brexit, earnings. We'll have more data on the cracks between the manufacturing side and the services side. As you know, you can have contractions in the economy without consumption going negative. I think for a three out of the last seven recessions, consumption stayed positive. If you just look at negative GDP quarters and you compare gross business investment versus consumption, gross business investment goes down most of the time you've had a negative GDP quarter, but then 60% of the time consumption stays positive.
McCullough: Yes. You're coming from such a high base. It's almost mathematically impossible.
Sonders: On the manufacturing and capex side of the economy, the multiplier effects and filter effects are bigger. It's not as simple as saying, ‘OK, manufacturing is only about 12% of the economy. Ergo it doesn't matter what happens there. As long as we have a healthy consumer we're fine for now.’ We have been fine.
McCullough: It's one of the favorite things for Wall Street to say, ‘The consumer is fine.’ You can say that 100% of the time at the end of every cycle.
On slide 54, I just want to show what Liz Ann said because I don't think people have an appreciation for what she said in terms of the PE expansion that we've seen this year. So what we're showing here is the the S&P 500 forward multiple versus the Russell. It's been bananas actually. It truly is game time on this metric. You've had a massive expansion in earnings expectations.
In the Russell's case, the return has been horrendous looking back to where the Russell peak back in August of last year. That's where a market starts to look extremely expensive because the “E” is falling down at a much faster rate.
Sonders: I still feel pretty confident in the overweight Large cap, underweight Small cap positioning other than the valuation discount on some metrics. The fundamentals of have small caps, be it the percentage of zombie companies, the high percentage of debt.
If you remember, the fourth quarter of 2017 there was a big burst of relative performance for small caps on the assumption that they were bigger beneficiaries of the tax code because they have a higher tax rate. The problem is the record percent of small caps at that time didn't have profits. I don't care what your tax rate was or what it goes to but you don't benefit if you don't have profits tax.
McCullough: It's classic Occam’s razor where Wall Street just needs something so simple when it's the cycle itself. Chinese stimulus in 2016 got earnings growth to go from negative to positive alongside U.S. tax reform in 2017. That's your comparison now. It'll be interesting to see how this all plays out.
You’ve spent time analyzing CapEx. CapEx has gone moderately negative on a year over year basis. What do you see there?
Sonders: I think that absent a comprehensive trade deal.
McCullough: You didn’t think that’s what we got last Friday? A comprehensive deal?
Sonders: When the comment is, ‘We have a deal contingent on it being written.’ No.
Absent a comprehensive deal, and the chances of that round down to something around zero, meaning full attention to intellectual property theft, tilting the bias away from state-owned enterprises and actually having enforcement mechanisms and monitoring mechanisms that doesn't appear to be happening.
China has basically said that. They don't seem to have much incentive for that. So you get some sort of skinny deal. There will be victory laps taken. But I can't imagine that under that those circumstances, you reignite animal spirits and kick back in the capex cycle.
However, if these nascent green shoots that we're seeing holds, after a 17 or 18 month decline in global PMIs, that’s positive. But I think CapEx does not represent the next leg in this cycle. So it’s all about the consumption side of the economy remaining strong enough.
McCullough: So you've seen these bubble multiple companies at 15 to 20 times revenues that nobody had heard before. Maybe it’s my bias having seen this before in the 2000s but it's really just a sine curve, isn’t it? Earnings are up against uncompable comps and capex is already slowing.
Sonders: Thinking about what keeps me up at night, I do worry about a bigger crack in the low end of the investment grade spectrum. When you think about the analogy of ‘When the liquidity tide comes out, you know who's swimming naked’ or ‘You throw a stick of dynamite in the water and the minnows come up first and then the whales later.’ So, you always have to wonder whether there are some naked swimmers out there.
I think heading into the next recession, it's more likely to be garden variety than an epic 2007 to 2009.
McCullough: That of course is the trap that people have, whether they're a whale or a minnow. They are constantly looking at the prior movie of 2007 and 2009 and seeing a replay of that.
Sonders: Yes, it's muscle memory and recency bias.