When Savita Subramanian, head of US equity strategy at Bank of America, raised her outlook for stocks at the end of last year, there was a lot of skepticism that equities could go any higher. The S&P 500 had already surged on expectations that the Federal Reserve would start cutting rates in 2024. And investors were very excited about AI. Then, in early March, she increased her year-end target for the S&P 500 even further, going from 5,000 to 5,400. Fast forward to the start of April, and the rally has continued even as markets ratcheted down their expectations for rate cuts this year. Of course, there are questions about whether investors are getting ahead of themselves and whether things are starting to feel a little frothy. In this episode, Subramanian explains why she thinks stocks can go up even further from here, how she's thinking about valuations, and why we shouldn't be too worried just yet about a repeat of the early 2000s internet bubble. This transcript has been lightly edited for clarity.
Key insights from the pod:
Why has the S&P 500 gone up? — 3:38
Bank of America’s 2024 S&P 500 call — 5:28
Are stock valuations too expensive? — 9:20
Measures of investor sentiment — 12:22
Stocks and the outlook for rates — 17:49
The resilience of stocks so far this year — 21:04
On incorporating big secular shifts like AI — 26:44
The potential return of diversification — 30:59
What would derail the rally? -- 24:04
The outlook for earnings — 37:23
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Tracy Alloway (00:17):
Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway.
Joe Weisenthal (00:22):
And I'm Joe Weisenthal.
Tracy (00:24):
Joe, for all intents and purposes, we are pretty much at a record in terms of US stocks.
Joe (00:29):
Totally. We're recording this April 2nd, so we're actually down a little bit today, about a percent. But this story, in my mind, of the market for 2024 is that we went into this year with all sorts of soft landing optimism. The Fed is going to cut rates a bunch of times, and then all these sort of rate cut hopes are sort of slowly evaporating, but it's hardly affected the stock market. And so we're basically at record highs despite the fact that that first cut keeps getting pushed out into the future.
Tracy (00:55):
Yeah. And the question is, are stocks going to start to turn lower? So again, they are lower today, they've been kind of vacillating for the past couple of days. Is this the start of a durable drop, or are markets basically catching their breath after a torrid rally and are they going to continue upward? Is all that excitement over things like AI and tech just going to keep going?
And speaking of excitement over AI and tech, you do see some commentary at the moment about bubble territory, so the idea that, well, maybe we're getting a little bit too optimistic, or isn't it weird that it was expectations of rate cuts that drove the move upward, but as the rate cuts get priced further out, we're not really seeing that big impact on stocks.
Joe (01:38):
Totally. So for a while, as the market was doing this sort of straight line up, really since the end of October when rates peaked, part of this sort of, I don't know, bear crowd or skepticism, or people are trying to poke holes in the rally is like ‘Oh, it's all tech. It's all the Mag7, these gigantic tech stocks, etc.
What's interesting about lately is that actually a lot of these high flyers like Nvidia, they've sort of been flat for the last month or so, and even that doesn't seem to be holding water. There actually are big rallies in many parts of the market.
So the question is like, why? I mean, you could say ‘Oh, the story maybe made sense.’ It's like ‘Oh, there's this handful of mega giants. They're capturing all of the gains. And so what these new all time highs don't really reflect what the broader market is doing. The broader market's doing fine.’
Tracy (02:27):
And again, against expectations. It's actually broadening out rather than becoming more narrow, which is the kind of thing that you would be worried about if you are in a bubble or about to enter a bubble.
But all right. I am very pleased to say that we do in fact, have the perfect guest to discuss markets and whether or not we are closing in on bubble territory, we're going to be speaking with Savita Subramanian, head of US equity strategy at Bank of America, and she recently raised her target for the S&P 500 from 5,000 to 5,400. I think this was done about a month ago, and we're already at like 5,200, so a good call. Savita, welcome to the show!
Savita Subramanian (03:09):
Hi. It's great to be here. Thanks for having me.
Tracy (03:12):
I feel kind of bad. I feel like we should have had you on way, way earlier. Because, you know, you are sort of a stalwart of the sell side research on stocks, and yet we haven't made it happen. Kind of weird.
Savita (03:24):
That is weird, but we're, we're correcting for past mistakes.
Tracy (03:28):
Yes. This is good, a good type of correction! All right. S&P 500 pretty much at record highs. What's driving it?
Savita (03:38):
Yeah, so it's interesting. When we launched our 2024 outlook in November with our year ahead report, and we launched our S&P market call with a 5,000 year-end target, and I remember having to repeat that number, like people would literally say ‘Did you just say 5,000?’ Like, it was way too high.
And now here we are at 52-whatever, and a couple of months ago, the market basically breezed right through that 5,000 target. And, you know, there's no perfect way to forecast a point in time target. In fact, I think it's kind of a silly number, but the question that we asked ourselves was, okay, now what? Does the market go higher or lower? Because we're kind of where we thought we would be by year end in January, and everything we looked at said higher.
So, you know, I can delve into it, but I think where we are now is still, we're sort of climbing that wall of worry. We're still in an environment where, I don't know, it's interesting. If you look at the average target for the S&P, I think it's lower than where the market is today, which is unusual because I think the sell side is usually skewed to being more optimistic.
When you look at even analyst earnings expectations, they're still relatively low outside of this. So-called, you know, Magnificent Seven or the, you know, mega-cap tech companies that have been driving the market. So I still think we're in an environment where allocation to stocks is just starting to increase. Bullishness is just starting to percolate. And as you rightly point out, the market is just starting to broaden out a bit.
Joe (05:20):
Let's go back to that initial call that you made for S&P 5,000. What was the reasoning then? Let’s just start with that
Savita (05:28):
So the reasoning then, and it was basically putting the S&P at around, I think it was like a 10% year or thereabouts, was the idea that, okay, where are we now versus where we were a couple of years ago? And I think there's a lot of good news that we should be happy about.
We should be happy that the Fed has actually moved interest rates from zero to five, because now we have a lot of latitude with which to ease our way out of the next crisis. We should also be happy that the S&P itself is pretty different today than what it was a couple of years ago. And I think, you know, what I find interesting is that the S&P 500 has basically managed out a lot of its own risk over the last couple of years by attrition.
So if you look at a lot of the companies that were in the S&P 500 in 2022, you know, when the big surprise was the Fed was about to hike interest rates by the largest amount ever in the fastest period of time. The constituents that were bigger weights in the market are now smaller weights, and maybe have even drifted out.
And in particular, the ones that have drifted out are those with refinancing risk or companies that might not be able to hack it in a 5% rate world. So I almost feel like the beginning of this year was a good start in terms of the health of the index. We also saw that despite this mega-cap tech dominance, these companies, they got expensive, but they didn't get as expensive as we saw, you know, non-profitable tech during the tech bubble of ’99, 2000.
Moreover, I think what's really exciting from a corporate finance perspective is that when you look at the risks around the S&P 500 based on higher interest rates, one of the things that worried us a couple of years ago was that the S&P itself was a very long duration instrument, i.e. you were buying today for like great growth, but it was way out in the future and you were getting no cash return today.
I think a lot of that has resolved itself because many of the less profitable growth companies have either drifted lower in market cap or have become profitable and are now returning that cash to shareholders.
So, you know, when we looked at companies in the big tech sector in early 2023, we started to see really encouraging signs. These big companies, these mega-cap tech companies, basically acknowledged that they were too big to grow as quickly as they had in a 0% interest rate world, and they were also just going to grow a little bit more slowly.
And you saw these growth stocks actually cut capacity, cut costs. Meta did the biggest share buyback that we've ever seen in the history of share buybacks. And, you know, these companies were able to lower their duration by pulling earnings earlier in returning cash to shareholders, etc.
I mean, the unthinkable happened earlier this year with Meta paying a dividend, or initiating a dividend. So I think, you know, the idea here is we're at a point where the market actually looks a lot healthier and much better able to navigate a higher rate environment than it did a couple of years ago.
Tracy (08:47):
So this is really interesting because you hear a lot of people say ‘Well, stocks look expensive at the moment,’ and I think Bank of America has a bunch of different metrics that you look at, and I think in one of your notes you said that the S&P 500 is statistically expensive on 19 of 20 metrics.
But the argument is that we've gone through this period of adjustment of higher rates and the mix of the index, its composition, has shifted such that, well, maybe those valuations are well-deserved?
Savita (09:20):
Well, to some extent it's the question, should we ever be comparing the market multiple to a prior market multiple, right? Because it's a different animal. And I think today as you said, you know, we're looking at an S&P 500 index that barely resembles the market in 1980 or even 1990.
We’ve gone from a, a market that was, you know, 70% manufacturing back in the 80s to an index that's 50% asset-light growth, healthcare, tech, innovation. We've gone from a benchmark that had much higher debt to equity ratios 10 years ago to a benchmark that's paid down a lot of its debt and now has fixed rate, you know, kind of long-term, less leveraged risk and less free financing risk than it has had in prior cycles.
I mean, 70% of debt sitting on S&P balance sheets is long-term fixed rate debt, versus back in 2007 it was something like 40%. So it's almost like comparing apples to oranges by saying ‘The market today looks expensive versus the market of 2000 or, you know, 1980 or thereabouts.’
So I think that's part of the problem. And then the other part of the problem is when you look at the S&P 500, it's made up of a whole bunch of different stocks. We all know this. But right now there is a skew where, you know, the growth companies that really benefited from this sort of free capital environment are bigger proportions of the benchmark and are potentially more expensive than the rest of the S&P.
So it's kind of like if you peel back the onion and you take out, you know, five of the mega cap companies, the market multiple drops from 20 to 15 or something pretty extreme. So I think there are a lot of problems with just looking at a snapshot multiple and saying ‘Yep, the S&P's at 25 times, and it's historically been at 15 times, you want to sell it.’ That's not the call we're making.
Joe (11:23):
So I will just give my full disclosure here, which is that I am an investor in an S&P 500 index fund. So I want to thank the active managers at S&P who have successfully gotten rid of some of the more rate sensitive stocks out of the index.
Tracy (11:40):
They’ve de-risked your portfolio for you.
Joe (11:42):
Yeah. So thank you for the excellent active management of my passive vehicle. You've already raised a number of really interesting points, but I want to go back to something you said in the first answer about sentiment.
Because capturing whatever the sentiment is at the moment is an inherently difficult task. You can look at market measures, what's happening with call options, you can do surveys. Bank of America does a survey of fund managers and they talk about their allocation. When you say that we're just getting into bullishness, it sounds weird when stocks are at all-time highs. What are you looking at when you say something like that? And when you say ‘Okay, people are just getting more into stocks now, what is the data that backs that up?’
Savita (12:22):
Yeah, there's a lot of data and you can basically get data to say whatever you want it to if you isolate your frame of reference to certain subsets. So I guess it's a complicated question and nobody really ever has a full kind of up-to-date look at what everybody in the world is holding.
And also, I mean, for whoever is buying equity, somebody is selling equity. So it's kind of like why does positioning even matter? So one of the things we look at is sort of who are the arbiters of inflows over the next, let's call it, three to six months, right? Individual investors are obviously part of the pie, but then there's the asset owners themselves. The pension funds, the sovereign wealth funds, the biggies that kind of engage in asset allocation decisions.
And I think what's interesting there is that you would think that asset allocators would be maxed out on equity exposure today given how well the asset class has done, how well stocks have done relative to other asset classes.
But if you look at the average US pension fund, their exposure to public equity -- to stocks -- is actually the lowest we've seen since the late 1990s.
And the reason is that a lot of these pension funds have supplanted their exposure to equities with exposure to private equity or alternative asset classes, or, you know, kind of less liquid ways to buy growth. And I think that's important because where we are today is an environment where pension funds have basically supplanted their exposure to active equity, like mutual funds and hedge funds, with an index fund.
But they've actually replaced a lot of that equity exposure with other asset classes in this search for growth. And I think that's potentially more problematic for illiquid asset classes like private credit and private equity, and asset classes that haven't necessarily been marked to this current environment of a little bit higher rates and inflation, than it is for public equity.
So that's one measure of positioning. The other measure of positioning that I've followed my entire career at Bank of America, and I inherited this from my former boss, Rich Bernstein, who was our strategist at Merrill Lynch for many, many years, and I think he may have inherited it from somebody before him, it's called the Sell-Side Indicator.
And the reason I always go back to this model is that it has been the most predictive market timing model for the S&P 500 over a 12-month time horizon -- more predictive than anything else I've been able to find. And what we do in this Sell-Side Indicator is we look at our peers and ourselves and we say ‘How bullish or bearish are we by virtue of one number, which is our recommended allocation to equities in a balanced portfolio?’
So when you talk to your broker and he or she tells you ‘We think you should put 60% into stocks and you know, 30% into bonds and 10% into cash,’ we take that stock allocation, we average it together across the entire Wall Street bulge bracket firms, and we look at what that average allocation is, and it has waxed and waned between something like 40% and 70%.
It's been all over the place over the last 30 or 40 years. But what we found is that when it's at very bearish or bullish extremes, you should do the opposite of what we're all telling you to do. And I think what's interesting is that we're not at a bullish extreme. We're at a point where your average market strategist is recommending that you put about 55% of your assets into equities, which is kind of surprising given that we've seen dramatic outperformance of equities relative to other asset classes over the last couple of years -- surprise gains in the S&P versus other indices.
It's a little bit surprising to see that there's still this very tepid allocation to stocks. I mean, the benchmark for years has been 60% stocks, and we're still shy of that. So it's not to say that folks out there are bearish and under the table and hiding and putting all their money in cash and gold and under the mattress, but I think we're at a point where we're far from that euphoric level on equities that typically heralds the end of a bull market.
Tracy (17:08):
How much of the rise in stocks is an interest rate story -- going back to the beginning of this discussion -- because part of the idea here is that, all right, well the Fed might cut interest rates, but the reason it would be cutting interest rates is because economic growth is deteriorating, maybe not substantially, but it's weakening a little bit. And so it's trying to get ahead of a potential recession or something like that. Is that perhaps why there's some reticence on the sell side to jump into stocks wholeheartedly at this point?
Savita (17:43):
You mean because of the fact that we're likely moving into a lower growth environment?
Tracy (17:48)
Yes, exactly.
Savita: (17:49)
Yeah, I think that is really the underpinnings of this caution. And I mean, if you think about it since the beginning of 2022, we had economists bracing us for this recession that was going to happen, and it was going to be in two quarters, and it kept getting kind of pushed out.
So we've been in this environment where we've been sort of waiting for this recession that hasn't happened. And it's hard to really pound the table on equities if you're expecting an economic recession, right?
Joe (18:24):
This is the wall of worry, basically.
Savita (18:25):
The wall of worry, yeah. And then I think on top of that, we've had healthy, attractive returns in the risk-free rate. So, you know, the TINA argument is now sort of debunked because you can get great returns in money market accounts, and you don't have to take any risk.
So I think that that's the other problem with allocating too aggressively to stocks. But you know, what's interesting is that if you go back over time and you look at allocations during periods when cash yields were this high, allocation to stocks were actually higher than where they are today. I think we're just in an environment where we're all so surprised that you can actually make any money off of bonds and cash after getting nothing for a decade, that it's almost made those asset classes that much more attractive or surprisingly attractive.
And I think there's very little acknowledgement that rates can actually continue to move higher rather than come down. So if you're bearish on stocks, because you can get better yield in cash, I get it. But if the Fed is about to start cutting interest rates and most of the assets sitting on balance sheets of individual investors are in money market funds and retiree accounts where they're looking for investments they can live off of, my sense is that as we start to see short rates come down, if that happens this year, they'll be forced to look for other areas of higher yield, which basically pushes them a little bit higher up the risk spectrum back into, you know, good old fashioned equity income or utilities and financials and even real estate companies. So I think those are some of the considerations that we're thinking about in terms of what is keeping investors on the sidelines when it comes to equities, but what could push them back into equities.
Joe (20:16):
So I want to press a little bit further on this idea of maybe it's not a contradiction, but that stocks have been fine even with the rate move up and even with ‘higher for longer’ becoming consensus. So I take your point that over long periods of time or medium periods of time, the S&P 500 is just not as rate sensitive as it might have been [at] times in the past when companies had more debt, had more assets, had more rollover risk.
What about, though, just the last two months? If someone asks you ‘Why haven't stocks gone down over the last two months after we keep getting these warmer than expected inflation prints? After that rate cut expectation keeps getting pushed out?’ This week we saw the odds of a June cut has now fallen below 50%. Talk about that ongoing resilience.
Savita (21:04):
I mean, I think it's really thinking about why the Fed's not cutting, and it's the idea that the Fed's not cutting because the economy is still running too hot, right? And again, I think that's not a bad environment for stocks, right?
I mean, so far we've sort of seen this proof of concept, if you will. So when you think about the last couple of years, I -- along with many -- was expecting to see margins getting hit harder by the fact that we went from, you know, negative inflation to 9% and then to five.
And you know, now we're a little bit lower, but it's kind of remarkable that margins remained relatively intact and healthy during that entire period of massive volatility around costs of everything, labor inputs, you know, lumber, everything saw a lot more volatility around cost than what we were expecting and than what we thought margins could actually withstand.
So I think that proof of concept, that you can have the corporate sector navigate that environment, you know, [and] still be able to price in many areas of the economy. The consumer hasn't slowed down meaningfully. I mean, there's been pockets of a slowdown, but in fact the average US consumer is potentially benefiting a bit from higher short rates by that spread between their assets and liabilities.
I mean, I think all of this, we've had two years of seeing the fallout of a massive move in short rates, and it hasn't necessarily derailed a lot of the equity market. It's certainly derailed parts of the spectrum. It's derailed, you know, commercial real estate. It's derailed parts of the private markets and the less liquid areas. But we haven't necessarily seen it play through to your average cash-rich company sitting on the S&P 500. Small caps haven't done particularly well, but I think they're perhaps a bit more refinancing- or credit-sensitive than large caps.
But I do think that, you know, we've had enough time to see that corporates can actually handle 5% cash yields. Some companies are benefiting, some consumers are benefiting, consumers aren't necessarily slowing down. We're still all gainfully employed. For the most part we haven't seen massive layoffs. We're still in a very tight labor market, in fact, in many areas of the economy. So I think those are some of the reasons that the market is remaining where it is.
Then I think the other kind of, I guess, harder to prove or harder to bear out in the data reason is that we are seeing some seeds sown for potentially a very strong productivity cycle. And I think that is the bull case from here, and we need to really all be paying attention to how that's materializing. But you know, I said earlier, we should be happy that the Fed has gotten us off of ground zero on interest rates.
And the truth is we're now at a point where there's a lot more certainty around earnings than there was a couple of years ago. A couple of years ago, a lot of companies were generating earnings growth, per share earnings growth, by borrowing money to buy back stocks. That's not a great high quality source of earnings growth.
And then even before that, we had globalization driving a lot of the earnings for the S&P, and you had cost arbitrage, tax arbitrage, basically global arbitrage. You know, if something was expensive in the US you could move somewhere else. And that was just this frictionless great story for earnings for, you know, for 20 years. But that is also risky, and we're now starting to see that because we're no longer friends with everybody. And you know, this whole globalization story seems like it's at least hit pause, if not reversed.
So I think today we're also at a point where we can be a little bit more, what's the word? Confident about company's abilities to continue to generate earnings, given that all of these easy, kind of lower-quality maneuvers are behind us. They've reversed and we've still seen companies able to adapt.
So I think that's another part of this story that's, you know, companies are now focusing on productivity. They're spending money on AI. We'll see if it works or not. But there is this promise that a lot of the more labor intensive companies in the S&P 500 can become labor light very quickly.
And we've seen this happen. I mean, I think what's remarkable is when you look at certain business models, they have vaporized overnight. Like the idea of a call center has basically gone away after generative AI was put out there. We've seen, you know, the need for Python programming completely evaporate because you can get AI to write your code for you. So it's kind of an interesting, very fast-moving theme that's already disrupted some industries and has the potential to really make a lot of these service sectors like IT services, financial services, legal services, that much more efficient.
Tracy (26:14):
One thing I always wondered, if you are a stock strategist looking at something like the S&P 500 and you think we are on the verge or in the early stages of a big secular trend. So for instance, the internet in the late 1990s, early 2000s, or the AI revolution right now, how do you start incorporating something like that into your forecast? Because it feels like it could be so transformative and there's no historical parallel, or not a perfect one.
Savita (26:44):
Precedent, yes. It's hard. I mean, we've been trying to think about, you know, well, there's a few angles. One is the revenue angle, which is already in play, and that's the idea of the CapEx takers. So if you have some theme, be it the PC revolution or industrial automation, there's the company that benefits.
And if you look at robotics companies or you know, Nvidia or chipmakers, those are the CapEx takers. And we've seen those stocks do tremendously well. If you think about the next leg, which is probably a longer leg, it's the first movers in industries that buy the stuff and get it right. So, you know, it's basically the first company that buys the right chips and implements them successfully to replace a big chunk of their expensive workforce. And that company could see margin expansion and bump up in their multiple.
I would argue that margin expansion might be short-lived if the process can be replicated across the industry. So I think we move from the CapEx takers to the first movers to the process being commoditized and priced in across the industry.
But at the end of the day, when you look at the companies that have used these tools to transform themselves, the entire sector should trade at a lower risk premium because those earnings are potentially stickier and easier to predict than they would be if you had to worry about this very cost intensive and risky labor force. People are risky, processes are less risky. So I think that's the sort of the evolution of this, the way I see it.
And then what we did was we looked at prior cycles, like we looked at the 1980s and 90s to see, you know, how automation benefited companies. And what was interesting to see is that over that entire time period within sectors, the peers that became labor light versus the peers that didn't become more efficient, the labor light companies outperformed their labor intensive peers.
So our view is, okay, we've got this opportunity for big chunks of the S&P 500 to become less labor intensive and based on our performance data, labor intensity and improvements in that metric have actually translated into alpha. So [this is a] long kind of convoluted argument for how you track this.
But I think right now all anybody's focused on are the CapEx takers and the chipmakers and the tech companies. Maybe now we've moved on to power and grid, but I think at some point we're going to start acknowledging that there are these industries that are likely to be transformed. There are some industries that are going to go away, other industries that are going to pop up, you know, like any tech revolution, this is going to take away some jobs, but it's also going to create jobs.
And we're seeing that real time with Python. I mean, you know, it's interesting if you talk to a graduate in an engineering program, well, I don't know, maybe it's different now, but you know, maybe six months ago I was talking to some recent grads in a program that I'm affiliated with and they were saying that, you know, the software and the coders were not getting jobs, but the hardware folks were getting jobs.
So that was just a big, big transformation right away that was disrupting jobs, but creating like a tightness in jobs in other sectors. And I think that's just what we have to kind of think about and try to anticipate in a smart way. So we're listening to our fundamental analysts on every sector. And what's fascinating to me is when we have calls on AI and its use cases, it's not just tech analysts that participate in these calls. It's healthcare analysts, insurance analysts, you know, really old economy businesses where there are potential transformative measures in place.
Joe (30:59):
I mentioned before investing in an S&P 500 index fund and in the investment industry there's always this preaching of diversification. And you mentioned that, you know, right now maybe people are at 55% or people are in various alternatives, or from time to time they’re like ‘Go international, buy international stocks or rotate to small caps,’ or whatever.
But for the last 15 years, more or less, we really all should have just had all of our money in QQQ -- no for real, right? We've almost been punished for being the good diversifiers that we're supposed to be and then we really shouldn't have [done it]. What changes that? What kind of regime shift would you want to see such that it's not always just like this sort of inexorable sucking of value towards a handful of leading edge tech companies?
Savita (31:45):
Yeah, it's such a good point. I mean, I suppose I would argue we're seeing that now, and maybe -- by ‘now’ I mean, you know, March, but not anytime earlier than that. But it's really the idea that we are starting to see earnings broaden out beyond just these thematic stories.
So, you know, it felt like last year we were just jumping from theme to theme. So it was, you know, AI was doing well and financials were doing poorly, then it was GLP-1 and, you know, kind of anti-obesity and it's different theme, different month. This month there's a lot of interest in power, and utilities have actually outperformed on some of those themes.
So I think that where we're starting to see that idea that diversification is important is when you look at just within the S&P 500, which is what I know best, we have seen this sort of broadening of the market occur. So in March, I think something like 60% of S&P companies outperformed the index versus less than 50% in prior months, you know, going back to December.
So we're at a point where we are starting to see the average stock outperform the index rather than the index outperform the average stock. And I think that's a change and that is actually more normal than unusual. So historically we've seen the breadth of the S&P 500 remain a little bit higher than 50%, rather than below 50%. And I think that's something we can point to as a sign that diversification is starting to pay off again.
But you know, I think one of the reasons that diversification didn't pay off over the last 20 years or 15 years was that you had one single buyer of US Treasury bonds and that was the Fed. And the Fed was pouring trillions and trillions and trillions of dollars into US Treasuries. That's not a diversified investor. That's one theme, one asset class and one big huge monstrous buyer. And I think if that environment is behind us, we go back to a more diverse set of buyers buying different types of things.
Tracy (33:58):
Similar question I suppose, but what would give you pause at this point? What would make you nervous?
Savita (34:04):
Well, I guess what makes me nervous is, you know, every earning season we're listening for layoffs because I think the linchpin of consumption is not necessarily rates or the cost to borrow, it's really just having a job, right? I mean, if you have income and you have the ability to pay off your mortgage, you're not going to walk away from your house. When you lose your job and you have no option to pay off your mortgage, that's when you start to see things really deteriorate.
So I think one kind of bull case for the US consumer that we've been highlighting is, you know, we're still in a pretty tight labor market. I mean, we had this massive resignation during Covid, we had an aging population, we have fewer workers in manufacturing. Meanwhile there's this huge reshoring initiative brewing where companies are moving plant property and equipment back to the US from other parts of the world.
So I think that tightness in the manufacturing complex and the feed through to small businesses in those regions has been positive. But if that starts to slow down, that would be a negative and broad-spread job losses, I think would be what we'd worry about, to sort of end the consumption story.
You know, I also worry about the debt burden carried by the US government, but I think that's a harder problem to model into your equity market forecast, right? I mean this is like your question earlier on AI and how do you model these things into your outlook? I think it's hard to know how the debt to GDP burden of the US government resolves itself. Does this mean that the US sovereign, you know, 10-year Treasuries are more risky? Does this mean that the dollar is at risk of losing its reserve currency status?
Definitely not today because there's no alternative. But I think those are the more kind of problematic, longer-term risks that make me less Pollyanna-ish about the world than I might be. I, again, though, when I think about those risks, I don't know if they manifest themselves in the S&P 500 and in the public equity markets. I think they're more impactful to private equity, illiquid assets, real estate, you know, just basically bonds. And then just sort of the idea of the US as a high quality sovereign I think is the other kind of part of this that is harder to really fathom at this point.
Joe (36:39):
You know, you mentioned companies cutting costs, layoffs, and changing their cash management. I sort of came away from that whole period [thinking] US company operators are really good. Layoffs aren't good, especially mass layoffs. But the speed with which companies adapt, sort of pivoted. It was like many companies demonstrated pretty serious sort of management competence.
Just sort of in the few minutes left, it sort of goes in hand in hand with people have jobs, they're probably going to spend it, that'll keep support up. What are you seeing in terms of just sort of how EPS, earnings per share, or corporate earnings are tracking versus where you would've thought at the beginning of the year or six months ago or at the end of October when this rally really took off?
Savita (37:23):
Yeah, it's a great point. So we've seen margins hang in there. They've actually expanded a little. The big surprise – I always feel kind of surprised when I look at the data, even though I know it -- is that we had an earnings recession last year, right? We had companies and the overall S&P 500 had a couple of quarters of negative earnings growth. And that recession is now behind us and we're seeing companies recover.
I suppose when I look at earnings trends, I mean one reason that I think the market could start to broaden out even more than just a month or two, is that when you look at just the differential between high-growth tech companies and the rest of the S&P 500, that differential starts to narrow. Last year the only companies that were making money were the Magnificent Seven.
So it kind of made sense that they just crushed it. This year we're starting to see that differential between growth trends narrow. We're forecasting about 10% earnings growth this year, which is roughly in line with where I think bottom-up consensus is, maybe bottom -p consensus is a little bit higher. We're basically forecasting a broad-based recovery across sectors that we've already seen.
So it's the idea that we've already seen cost cutting and now maybe we see that operating leverage from demand coming back from parts of the economy starting to pick up again. We're seeing a shift from service spending to good spending. So that's positive for the S&P 500 and consumer stocks. Those are some of the areas that we're, we're looking at from an earnings perspective.
Tracy (38:56):
Alright, Savita, I'm so glad we finally had you on Odd Lots. Thank you for coming on.
Savita (39:00):
Thank you so much! It’s great to be here.
Tracy (39:16):
Joe, I'm so glad we could do that episode finally, because Savita has nailed the upwards trend in the S&P 500 at a time when a lot of people were still very nervous about the outlook for stocks.
The one thing that had me thinking, and I think we spoke about this before, but like the one recession path that I kind of worry about is the idea of like, I guess lofty EPS expectations kind of coming back to haunt the market in the sense that companies had pricing power in recent years. They raised their prices, that helped pad margins.
But if inflation is starting to go down or if consumers are starting to push back, or if there is pressure on household balance sheets or whatever, then maybe one of the levers they pull is on the job front, right? And then we get layoffs and then we see consumer power start to go down and then we see profit margin start to go down. And that would be bad. I'm not saying we're there yet, but like that's the one kind of path that I worry about.
Joe (40:16):
Totally. That makes a ton of sense to me. And also just this idea that, you know, on the service puzzle, why haven't stocks affected by higher rates? Well, rates are high because demand is strong and the economy continues to grow at a robust clip. And if people continue to have jobs, they'll continue to spend and if they continue to spend and earnings hold up, then you don't necessarily need those higher rates. So it's interesting that already this year, you know, rather than the scenario that you described, which seems very plausible to me, so far at least we're seeing the opposite. That broadening out effect.
Tracy (40:48):
It's a virtuous cycle at the moment. It could go in the other direction, but for now it seems to be feeding on itself in a positive manner. The one other thing I thought was really good to emphasize is that index composition change. And the idea that like, okay, you could look at historical PEs and compare and contrast with the 1980s or the early 2000s during the tech bubble or whatever, but there are actual changes in the S&P 500 that might make that comparison less useful.
And especially that point about companies terming out their balance sheets and the duration changes that we've seen. I think if you had a good handle on the degree to which companies had actually refinanced their balance sheets over the past couple of years, you probably would've nailed a lot of the resilience that we've seen in markets.
Joe (41:35):
Totally. I think it's really important this idea of like sort of earnings durability, quality. And so you can imagine that a company that has to hold a lot of inventory or a company that has to from time to time engage in huge capital expenditure cycles, like yeah, you probably don't want to pay as much for those earnings as you do a company that doesn't have to manage those risks the same way.
And so I think, I'm always a little bit scared of like ‘Oh, here's why the index doesn't matter. And that these you know, percentiles and 95th is not as scary,’ but it does make sense that there are certain types of earning streams that the nature of the business model is such where you can be confident that they'll be more durable than another type of company.
Tracy (42:19):
This has gone back to being a value-bashing show.
Joe (42:22):
Can I just say the one other thing I really like is that, you know, it is really hard to measure, as Savita said, how much allocation different types of investors have to stocks at any given moment and that’s why there's all these surveys.
I love that the one measure that seems to have some historical validity is to just measure the analysts themselves. And when the analysts are really bullish or super bullish, that's maybe time to sell like that. You just do the survey, look at what people are recommending and see how out of whack they are.
Tracy (42:52):
I'm looking at the sell side indicator that Savita mentioned right now and it is kind of crazy how much bullishness there was in say, like, 2001. It seems to work. Anyway, shall we leave it there?
Joe (43:05)
Let's leave it there.