From the December 2006 issue of Investment Advisor • Subscribe!

December 1, 2006

Catching up with... Liz Ann Sonders

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After the mid-term elections in which the balance of power in both the House of Representatives and the Senate shifted to Democrats, IA had to know: How could this change affect the economic picture? On the morning after the November 7 election, Liz Ann Sonders, chief investment strategist at Charles Schwab, who was in Washington, DC, for the Schwab Impact conference, sat down with IA Staff Editor Kate McBride and talked about the election, the rest of 2006, and her outlook for 2007.

What does the Democratic majority mean for advisors and their clients?

I don't think it means a heck of a lot; I think it will be a lot of rhetoric now that may cause some issues with the market, particularly at the sector level. There will be a lot of hearings, so there's some uncertainty, but as far as actual policy change, I think that will be limited, certainly in the Senate by virtue of a tie or pretty close to it, and even though in the House the Democrats picked up a pretty decent majority, Bush still does possess the veto pen. But in the early stages of this, given the hearings that are likely and a lot of the commentary, whether it's prescription drugs or minimum wage, could cause some ripples in the market.

Was part of this outcome discounted already?

The outcome in the House was absolutely discounted. I don't think the market's rally had much to do with politics. The work I have done suggested this rally has been a function of short covering by hedge funds that just could not stand the pain of being short anymore. The biggest 10 days or so of the rally that defined the vast majority of the move were all big short covering days, so I actually have not tied much of the market's movements to the election at all.

Nancy Pelosi will be Speaker of the House, with an agenda including stem cell research, raising the minimum wage, transitioning in Iraq, and a look at middle class taxes. How do you think these things will affect the economy?

We don't know. It's a question, again, of how much gets done. One can talk about it but ultimately it has to become policy for it to have an effect. The market probably will devote a lot of attention to the minimum wage hike and also, obviously, to tax policy because I do believe that part of the reason for the long-term market rally--i.e., the bull market beginning from the end of 2002, certainly the liftoff we got from the market lows of 2003--had a lot to do with the capital gains and dividend tax cut

What's your outlook for the rest of this year and the first half of 2007?

The rest of this year could have a trouble spot or two--we had such a singular move without any kind of corrective phase for a pretty extended period of time now...We're looking at some sentiment measures now that suggest, maybe, we're a little bit troubled. There's a lot of complacency. I think the market has this somewhat rose-colored view that we have engineered that elusive but perfect soft landing: that inflation is kicked, that the Fed is out of the game, that the next move will be a cut--but it won't be a cut because we're risking a recession; that the yield curve is inverted not because of any problems in the economy, but because of excess liquidity that has just pushed yields down on the long end. It just seems almost a little bit too pat. Valuations are reasonable, earnings growth is exceptionally strong, but it's been exceptionally strong for a very long period of time and we may not be at the peak, but there's a disconnect in a quarter when you have 19% earnings growth and 1.6% GDP.

When you look at recent trends in productivity and unit labor costs, it suggests that the profit margin story, which has been stellar, may start to become less stellar... but I think housing is the key. If you can answer all the unknowns about housing, you can answer the questions about the ultimate path the economy is on, and in turn, the market.

What about housing?

I spent time with Alan Greenspan yesterday and the most interesting comment, for me, was he seemed to be not less optimistic about housing, but he was so well quoted a few weeks ago in suggesting that the worst in housing was over, and when I posed the same question to him he was not as definitive that the worst was over. He suggested that maybe it gets a little bit worse. . . Maybe the plunge in prices is past its most severe point but when I think about $2 trillion of resets yet to kick in between now and 2008 and all of these packaged mortgages and $300 trillion in derivatives in general, a lot of it tied to housing, and the employment side of it--I've seen numbers as high as 40% to 45% of all jobs created in the last five years had some association with real estate--I'm having trouble putting my rose-colored glasses on when I look at housing.

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