Our Philosophy and What Matters in the Markets

KATHY JONES: I'm Kathy Jones.

LIZ ANN SONDERS: And I'm Liz Ann Sonders.

KATHY: And this is On Investing, a new original podcast from Charles Schwab. Each week, we're going to bring you our analysis of what's happening in the markets and how it might affect your investments.

But before we get to that, I think we should talk a little bit about why we're doing this and what you can expect if you follow the show and listen regularly. Right, Liz Ann?

LIZ ANN: Absolutely. One of the things my daughter often says to me is, "Mom, get to the point." So I guess that's what we're going to do here is—"What's the point of this?" And you and I have both done just a ton of media over the many years we've been in this business, but we've always wanted to do a podcast, something you can listen to while you're commuting or running. I don't run. So, for me, it's walking, walking the dog, and maybe just as important something you can go back and listen to later. It's not live and it's not TV. And one thing I have found that's so great about podcasts is you can go back and listen to it whenever that fits in your schedule. And the idea with this podcast is that we'll each give our perspectives on the markets, our areas of expertise. We'll bring in some other people from within Schwab, outside Schwab to share their analysis and stories as well. And if you don't know us, I figure we should introduce each other.

So let me go first and introduce you, Kathy. So Kathy is Schwab's chief fixed income strategist, and what that means is she analyzes the bond market. She and her team look at everything from short-term interest rates to long-term municipal bonds to junk bonds. She also provides fixed income education for investors at Schwab. Kathy has been an analyst of global credit markets throughout her career, working with both institutional and retail clients.

Now, Kathy joined Schwab in 2011. She's heard me say this. She's heard the chuckles in response, but I don't say it in jest. That was a great year for me when we brought Kathy on, because that was when I was able to stop pretending like I was an expert in the fixed income market. So Kathy was a fixed income strategist with Morgan Stanley Smith Barney—boy, that's an old name, or at least part of it—where she specialized in global macro strategy, covering both domestic and international bonds as well as foreign exchange.

She has also been a consultant in alternative investments and was executive vice president of the Debt Capital Markets Division at Prudential Securities. Kathy received her bachelor's degree in English literature with honors from Northwestern University and her 'master's of business administration in finance, also from Northwestern.

I'm sure you've seen Kathy on CNBC, Bloomberg, CNN, other places. And interestingly, she's also active, we both are, in Schwab's Women's Investing Network and our mentoring programs. So over to you, Kathy.

KATHY: Well, thanks, Liz Ann. Thanks for all that. And yes, you're right. There's a couple of old names in there that aren't around so much anymore.

Now it's my turn to introduce you. Liz Ann Sonders is Schwab's chief investment strategist. So she's responsible for a lot of our market and economic analysis and investor education, all focused on the individual investor.

Liz Ann is regularly quoted in financial publications, including The Wall Street Journal, The New York Times, Barron's, and Financial Times. And she appears as a regular guest on CNBC, Bloomberg, CNN, CBS News, among others.

Barron's has named her to its 100 Most Influential Women in Finance every year since the list's inception. And Investment Advisor has included her on the IA 25, its list of the 25 most important people in and around the financial advisory profession. Liz Ann also has been named to Forbes' 50 Over 50, although I don't believe she is over 50.

LIZ ANN: Well over 50.

KATHY: Well, you don't look it.

In 1999, Liz Ann joined U.S. Trust, which was acquired by Schwab in 2000, as a managing director and member of its investment policy committee. Previously, Liz Ann was managing director and senior portfolio manager at Avatar Associates, an original division of the Zweig Avatar Group. She held an MBA in finance from the Gabelli School of Business at Fordham University and a BA in economics and political science from the University of Delaware.

She's also vice chair of the board of trustees for Nantucket's Boys and Girls Club, which follows 12 years on the board of Make-A-Wish Foundation.

OK, so that's who we are. Let's talk a little bit about our own philosophies and what matters to us when we're looking at the markets. Liz Ann, you've worked in this business for quite a while, but how has your approach evolved over time? What's your overall approach to looking at the markets and the economy?

LIZ ANN: Sure, and yeah, it is quite a while, and I don't shy away from years in terms of age or experience. It's 37 years for me. I think you have me beat by a couple of years. But as you mentioned in the intro, Kathy, I started in this business in the mid-1980s working for the late great Marty Zweig. I was on the institutional side of that combined organization where Marty was running the mutual fund side and a hedge fund. And he had what was the most popular investment newsletter at the time. And I learned really a lot about the markets from Marty.

He was, I guess, known as a market timer, but it was a very disciplined process. He wasn't trying to bombastically forecast tops and bottoms but take a really disciplined approach looking at monetary liquidity and investor liquidity, which to some degree are kind of fancy terms for Fed policy and investor behavior and sentiment. So my learnings were sort of steeped in that analysis and very much tied to things that he became well known for believing in and saying, probably the most famous is, "Don't fight the Fed." A lot of people don't realize that was his sort of coined phrase, and everybody uses it now. But there's a lot of truth to that. I'm sure we're going to spend plenty of time on this podcast talking about the Fed and implications for markets.

KATHY: Now, Liz Ann, I know that you have some other quotes that you keep handy. Things that you probably have in your brain right now, you've memorized, that are important to you and your philosophy. Could you share some of those with us?

LIZ ANN: Sure. I'll never forget the first book that Marty gave me to read about the market, and it's one I recommend all the time to people. It's a short book. It's a paperback. It's an easy and fun read, and it's called Reminiscences of a Stock Operator by Edwin Lefèvre. And I have this quote written down from the book, which I always have in front of me because I think it really frames the environment and what is truly important in terms of how markets behave, and in turn, how investors behave.

And the quote from the book is, "The sucker has always tried to get something for nothing. And the appeal in all booms is always, frankly, to the gambling instinct aroused by cupidity and spurred by a pervasive prosperity. People who look for easy money invariably pay for the privilege of proving conclusively that it cannot be found on this sordid earth." And it really gets to the heart of the emotional side of investing. And it's one of the things that I spend a lot of time focusing on when I write and talk to our investors is about the differential between financial risk tolerance and emotional risk tolerance and how that can sort of trip up investors.

Another quote that I have on this dog-eared piece of paper that I think about a lot is from the, still around in his '90s, Burton Malkiel. And it's, "It is not hard to make money in the market. What is hard is to avoid the alluring temptation to throw your money away on short, get-rich speculative binges. It is an obvious lesson, but one frequently ignored."

And the one that, Kathy, you've probably heard me say a million times, but I think it's a beautiful thing in describing market cycles is Sir John Templeton's "Bull markets are born on pessimism, they grow on skepticism, they mature on optimism, and they die on euphoria." I don't even have to have that written down. It's so ingrained in my head.

But I think ultimately that probably defines market cycles more than just about anything else. We all as analysts or strategists focus on things like valuation and breadth and technical conditions and earnings and the connectivity between the market and the economy. But if you think of some of the major market cycles, some of the big ugly bear markets we've had or the booms on the upside, there was a lot about animal spirits and fear and greed and psychology. So everything that I do, there's always an eye on that psychological aspect of things. Again, in addition to things like breath conditions—the participation of the market relative to maybe at times a small handful of names. That's certainly been an environment this year of the concentration associated with the, we've been calling it the Super 7, and then Magnificent 7 sort of became the popular descriptor. And I like that one, so I'll use it.

So what sits behind eras like that, the earnings backdrop, the so-called mother's milk of stock prices. But even with earnings, it's not necessarily what you might think in terms of market behavior. Actually, the strongest earnings growth historically has not been met with decent or even positive market returns. That's often when the market struggles because of the market as a leading indicator. And that's another key thing that is part of my philosophy and, I think, important for investors to understand is as it relates to the economy. There are leading indicators, there are coincident indicators, there are lagging indicators, truly understanding which fit in which bucket, but also understanding that the stock market is a leading indicator. So how it interacts with those various subsets of indicators, that's tied into a line I say all the time, which is, "When it comes to the relationship between economic data and stock market behavior, more often than not, better or worse matters more than good or bad." So it's rate of change. It's direction. It's inflection points.

So spend a lot of day-to-day time just doing that kind of analysis, some top-down work, some bottom-up work, but also reinforcing the power disciplines of things like diversification and rebalancing. Again, financial versus emotional risk tolerance. And importantly, understanding that we don't try to time markets because nobody can do that successfully. One of the first conversations I had early on with Chuck Schwab, our founder, was around just this. And I think we had sort of a like mind in believing that too many investors believe the key to success is knowing what's going to happen in the market or knowing who to listen to that thinks they know what's going to happen in the market and then positioning accordingly. But the reality is it's actually not what we know about the future that makes us successful investors. It's actually what we do along the way. And that's why in Chuck's memoir that he wrote a few years ago, one of the, I think, best lines was, "If I had learned anything after years in the business, it was how little I could ever know about what the market would do tomorrow."

So that's the broad philosophy. We'll go into a lot more detail on facets of that as we go through the next several weeks, but I want to turn to you, Kathy, and ask the same question. How do you approach the markets and then the Fed? How do you spend your days?

KATHY: Yeah, Liz Ann, I don't have any great quotes for you. But I will say, I came up … my first job in this business was in commodity futures trading. So it was very valuable because I didn't know much about markets at the time. Didn't know anything about markets at the time, so some 40-odd years ago. And what I really learned very quickly was the importance of risk management. I saw a lot of very successful traders come and go because they didn't know risk management or didn't practice good risk management. So, for me, that's kind of an underlying theme that I look at is, you know, what's the upside/downside here? How do I protect myself? What's the best way to approach this to, you know, maximize returns relative to risk? And that, I think that philosophy underlies pretty much everything that we do in the fixed income area.

I will say the major factors that I watch, there's three that just pop out as the major drivers of interest rates, and that's going to be Fed policy. You can't ignore the central bank. Unlike the stock market, you've got one entity in the U.S. bond market that plays a huge role in terms of determining what the base lending rate is and how much money is circulating through the markets. And so we have to pay very close attention to what they're telling us, what they're doing, what they're not telling us, and try to parse through all that. And obviously that's challenging, but we can't ignore what the Fed is doing. It's the most significant driver of yields over time.

Then we look at inflation. Inflation is the enemy of the bond market, so we have to pay really close attention to what's happening there and how inflation and inflation expectations are moving because that's a big component of what drives fixed income markets as well.

And then economic growth. So there's a strong correlation between interest rates, Treasury yields in particular, but also yields in the corporate bond market and the municipal bond market, and how the economy is moving, and how fast it's growing, whether it's growing, whether it's shrinking, etc. And that's clearly then there are a bunch of indicators that we watch in terms of economic growth.

And then when we get just outside of the interest rate environment and look at corporate bonds or municipal bonds, we have to focus on the underlying fundamentals such as the ability of the issuer to pay, what the yields are relative to Treasuries, which are the benchmark, the effective tax rates, and then just a range of other issues. So we do a lot of number crunching. I'm still a diehard Excel spreadsheet user, even though I know that there are more efficient ways to go about it, but haven't really changed that habit of mine to take the data and look at it and try to assess what it's telling us.

In terms of philosophy, in addition to risk management, we try to build off a fair-value estimate and extrapolate from there. Not easy to come up with that estimate, but we have confidence intervals around it that are important to us. We include the global outlook, so we also cover global bond markets and what other central banks are doing because that clearly is an important driver of what happens in the U.S. markets. We look at how the dollar is acting against major currencies. That's another factor that's important in terms of how the central bank set policy and how the flows in and out of the market turn out. And we just take in as much as useful information as we possibly can, do as much research as we can to verify things that we're seeing, whether they're actually true or not true, or whether they prove to be valuable or not valuable.

So, you know, I guess the last thing is I'm always looking for what I'm missing. How am I wrong? It's not easy. No one's right all the time. And I think the most valuable lessons that I've learned over the years is when I look at what I got wrong, and I have learned a great deal of humility in this market. But I look at, well, how did I get it wrong? Why did I get it wrong? And what can I learn from this going forward?

I will say, unlike you, Liz Ann, I don't pay a lot of attention to sentiment readings. You know, there's an old saying that "Bonds are about math and stocks are about stories." I'm not sure that that's 100% true, but I haven't found sentiment readings to be all that valuable in the bond market. So it's a little bit different, I think, from the stock market in that it does kind of come down to the math at the end of the day.

LIZ ANN: Yeah, I totally agree. Kathy, you had one of the funniest lines a few months ago. I think we were both speaking at one of the Schwab conferences and somehow the subject came up of the differences between the bond market and the stock market. And I often say, and this gets more to the weeds of things like data, that the bond market lives in the real world and the equity market lives in the nominal world. But you made a comment about the equity market being like a Labrador puppy. And as someone that, a year ago, I had three yellow Labs. The oldest, Oscar, we had to say goodbye to about a year ago, but at that time, our now two-year-old was a puppy—he was one. And when you said that, I immediately thought of my elder statesman, calm Oscar, who just was very observant about what was going on around him as your analogy of the bond market and my maniac, dastardly one-year-old Wilbur who anything could distract him, anything could excite him. And so I had my own yellow Lab versions of the of the bond market and stock market. I'll never forget that comment.

Anyway, back to the idea of this podcast. So going forward, it's going to come out on Fridays. So that will give us the chance to look back at the week, but also look ahead to the following week and even beyond.

Now, since this is our first episode, we decided to go a little bigger picture to set a broader stage for what we hope, anyway, are many interesting conversations in the weeks and months to come. So I'll turn it back to you, Kathy. What is your view on where we are right now, your broad outlook for fixed income and Fed policy, especially given just what's been an incredibly unique year and a volatile period for the fixed income markets?

KATHY: Yeah, to say the least, it's been a volatile year and one that hasn't been easy to navigate, I don't think, for anyone. From a big picture point of view, you know, I would say that we're in the process of establishing a new normal in terms of interest rates or maybe returning to an old normal. I think it remains to be seen. You know, we've had this abrupt shift over the past 18 months or so when we went from near zero interest rates to over 5% for the fed funds rate. So huge shift in a very short period of time. So I think the bullet points are the era of zero interest rates has ended. It's even ending in Japan, it looks like, which has been … they've been in zero interest rates for 20-some-odd years. And we're into a return to positive real interest rates, meaning the nominal yields are above inflation rates. And that's not something we've seen for a really long time and has implications for the economy, for broader markets.

We've got now a risk premium in the bond market, something we, again, we haven't had for a long time because we had the Fed and other central banks holding yields down. Where it was a negative risk premium, now we actually have a positive risk premium. And that … in textbooks, you're supposed to have that, right? You're supposed to have some risk premium in your investments, particularly for longer-term bonds. So we're back to that. And, you know, we have the highest real interest rates in more than 15 years.

So a very different environment that we're dealing with. It's a challenge. And I don't think that anybody, including the Fed and other central banks, really has a good handle on where the new equilibrium interest rate should be. That's what everyone's searching for. I'm not sure that we've found it yet because a lot of this volatility, I think, reflects the fact that the market and the central banks and all of the various investors are trying to figure out, well, where is that new kind of neutral that makes sense? And it's likely to be a pretty bumpy ride to a more stable level.

But I think the good news is that for investors that can ride out the ups and downs, this is a good time in fixed income. We had a very long stretch when there was no income in fixed income. And we're encouraged. Once we get past this volatility, settle down a little bit, figure out … bring buyers back in who have kind of been on strike. I think that what we'll find is still these positive real rates for people. So, for us as fixed income investors, you know, that's a real opportunity and one we haven't seen for a while.

So that's where we are right now. What about you, Liz Ann? You've certainly had your share of volatility lately in the stock market, in the economy. Things haven't turned out quite as the rule books would say. What's your take right now?

LIZ ANN: Yeah, to say this has been a unique era, cycle, whatever you want to call it, is the ultimate understatement with so many threads associated with the pandemic weaving into what has made this cycle so different in the economy, in market behavior, and it's perplexing for a lot of investors. On a day-to-day basis watching action that at times doesn't make a lot of sense, the unbelievable cross currents in terms of economic data, this constant debate around recession versus soft landing and if it is truly different this time. And I forget who it was that said that those are dangerous words, "It's different this time." I think I take the other side of that. I think it's always different this time in both the market and the economy.

But one of the themes that we've been emphasizing in describing the economic cycle, but it ties into the market action and cycle and behavior, is this idea of a rolling recession, which isn't, you know, it's a term that's been used more often than not these days by a number of people, but it's not as common as the more simplistic traditional recession or soft-landing type terms. But I think it's an apt way to describe this cycle. And none of us want to relive the last three and a half years, and that's not my intention to do that. But going back to the worst part of the pandemic, I think, frames the start of this unique cycle because at the time when we were in lockdown mode and the economy was suffering from its COVID recession—when the stimulus kicked in, obviously both on the monetary side of things as well as the fiscal side, the demand associated with that fueled by stimulus was unbelievably powerful but very much funneled into the, call it the goods-side of the economy because as we all remember, there was no access to services, and that helped launch the economy out of what was that very short-lived recession. But it was very concentrated in certain segments of the economy. That was also the breeding ground of the inflation problem with which we're still dealing, but very much concentrated in the goods categories associated with inflation statistics.

Well, fast-forward to the more recent period, you have the offsetting strength on the services side of the economy. Services is a larger employer that has kept, or at least helped keep, the labor market afloat. But many of those areas that had that initial burst went into their own individual recessions or their own individual hard landings, however you want to describe it. But it's big areas in the economy like manufacturing, housing, housing-related, a lot of the consumer-oriented goods that were actually beneficiaries of the lockdown phase.

And it's had implications for the stock market too. The idea that the stock market is just completely whistled past any, you know, air quote "recession risk," perceived or otherwise, suggests that you're forgetting—which, you know, that's a lovely thing if you can forget things like bear markets, but we did have a bear market last year if you're using just the definition of top to bottom before another 20% rebound. That was from the beginning of January last year until the middle part of October. And you had many of the segments in the market that reflected where that initial strength was. I call them the growth trio of sectors—technology, consumer discretionary, communication services. They got crushed in last year's bear market. They were the worst three sectors with drawdowns from peak to trough in the 35 to 40 percent range. And I think that was connected to what was going on at that time. That weakness that was showing up in areas that had that initial strength. And now we're still in an environment where the labor market has been resilient and probably longer than just about anybody would have expected, particularly given that the Fed is not directly trying to harm the labor market and ratchet up the unemployment rate, but they do believe that some weakness, or at least less tightness, in the labor market is a necessary ingredient to not just bring inflation down to their target but keep it there in a somewhat sustainable way.

But it brings up a bigger picture view that we have that I'm sure we're going to talk about in a lot more detail. But for me, it's the let's set the stage with a longer-term view. The era that essentially ended with the pandemic is often referred to as the Great Moderation, depending on what metrics you're looking at or what relationships or who is using the term. It covers different periods of time, but I think of it as starting in the mid- to late 1990s and going through to the pandemic. And it was an era of very restrained inflation, very little inflation volatility, very little economic volatility, the incredible tailwind of declining interest rates nearly the entire time, including the two eras of 0% interest rates and the Fed doing what it did with its balance sheet. And you had longer economic cycles, fewer recessions. I think that that environment is not what we're heading back into. I think most of the conditions that supported that era of Great Moderation—some of it had to do with globalization. As you know, I know, Kathy, you and I are on the same page with not thinking what we're experiencing now is de-globalization. It's just supply chain diversification and some on-shoring and thinking more "just in case" instead of "just in time," but also … an acronym that we've been using to define some of the drivers of the Great Moderation was GEL. Everything was GELing, G-E-L. And that's because the world had cheap and abundant access to goods, energy, and labor. The goods and labor side of that had a lot to do with China coming into the world economic order and really just flooding the world with cheap manufactured goods and the labor to produce it.

In the case of energy, there was less geopolitical instability. You also had the booms in the U.S., the fracking and shale booms, which led us to become essentially energy independent. And I think what we're seeing now is, I think, a return to a different environment, maybe not exactly like what I've been calling the Temperamental Era, which is the 30 years that preceded the Great Moderation, call it from the mid-60s to mid-90s. But that was an era that looked a lot different. It had more inflation volatility. That, by the way, is not the same thing as saying inflation is going to stay high in perpetuity, but more inflation volatility driven by more economic volatility, geopolitical concerns, climate change, the list goes on.

But the one relationship that's interesting to ponder, and this is—I'll end with this because it wraps your world and my world together—is the relationship between the bond market and the stock market. And what a lot of people don't realize is that the 30 years prior to the Great Moderation, essentially the entire time from the mid-60s to the mid-90s, with very few exceptions, bond yields and stock prices were inversely correlated. And that in simple terms, just to use an example, was because in that era of more inflation volatility, often when yields were rising, it was because inflation was reaccelerating. And even if growth was picking up, that was more of a negative backdrop for equities, and vice versa when yields were coming down. Well, because inflation was not much of a concern during the Great Moderation, yields and stocks became positively correlated because in that era, if yields were moving up, it was often reflective of better growth without the attendant concern of a major inflation problem, that sort of nirvana for equities. And we're back in negative yield territory—whether it persists there, that's just something we're all going to have to watch. But it means potentially a different backdrop. And it's not without opportunities for investors, but for a lot of investors who don't have an investing history back beyond, say, the mid 1990s, it's just a different environment and hopefully one we will help everybody navigate.

So that is it for us this week. Hopefully we did a decent setup and a backdrop from a bigger picture perspective for some of the conversations we're going to have down the road. And we'll be back with a new episode next week. We also will have a variety of guests on the show—some folks within Schwab, some really interesting and exciting external guests, and we're going to be introducing some recurring segments as we go along.

KATHY: Yeah, Liz Ann, I'm really looking forward to what we have planned in the coming weeks. Have some very special guests I've wanted to speak with on record on podcasts coming up, so excited to talk to them.

Thanks everybody for listening to our first episode. Be sure to follow us for free in your favorite podcasting app. And this really helps us—tell a friend about the show.

If you want to keep up with the charts and data we post in real time, you can follow us both on Twitter or X or LinkedIn. I'm Kathy Jones. You can find me on Twitter @KathyJones, that's with a K, and on LinkedIn.

LIZ ANN: And on X, formerly known as Twitter, I'm @LizAnnSonders. Now I've had a lot of imposters lately, so make sure you're following the real @LizAnnSonders. There's no special characters. There's no E on the end of Ann. And Sonders is with an O, S-O-N-D-E-R-S. And I'm also on LinkedIn.

KATHY: For important disclosures, see the show notes or visit Schwab.com/OnInvesting, where you can also find the transcript.