Schwab's Sonders: Where to Invest as S&P Tops 4,000

What You Need to Know

History suggests another triple-digit gain this year is unlikely but possible.
Strategists still see value in quality stocks and value stocks.
Schwab expects financials and health care to outperform, Sonders says.

The S&P 500 index set another record high on Thursday, rising more than 1% to close at 4,019, buoyed by growing optimism about economic growth.

The $1.9 trillion economic relief plan signed by President Joe Biden in March coupled with his plans to spend even more ($2.25 trillion) on infrastructure investment and the growing number of Americans vaccinated for COVID-19 underpin that optimism.

Along with that positive outlook are some growing questions about how far the rally can go and how long it can last and whether the some parts of the U.S. stock market are overvalued.

But some sectors of the stock market may have more room to run, Liz Ann Sonders, chief investment strategist at Charles Schwab, tells ThinkAdvisor.

What History and Valuations Tell Us

Nicholas Colas, co-founder of DataTrek Research, notes in his latest briefing report that it’s very unusual for the S&P 500 to post double-digit gains three years in a row — it gained 31.2% and 18% in 2019 and 2020, respectively — though not unheard of. “Could that happen again with an accommodative Fed and a Democratic President and Congress pushing for more fiscal aid? Yes, as long as rates don’t rise too high,” writes Colas.

But he cautions that “corporate margins were already at record highs after the Trump administration’s tax cuts … and the Biden administration is also now, of course, trying to raise corporate taxes.”

Morningstar analyst Dave Sekera writes in his Quarter-End Insights report that the broad U.S. equity market is 3% overvalued even after accounting “for a strong economic resurgence in 2020” that carries over into 2021, but many individual stocks are not, including many value stocks, which have outperformed year to date.

Through March 26, the Morningstar U.S. Value Index surged 13.39% while its U.S. Growth Index fell 0.53%, and the firm’s U.S. Small Cap Index gained 11.87% while large-cap stocks gained just 4.68%. “Value stocks should benefit from the strong economic resurgence in 2021 and 2022 … but … we no longer expect small-cap stocks to outperform.”

“It’s not all blue skies,” write Bank of America Securities strategists, in a recent market note. “The market appears to already be pricing in additional stimulus and the focus is shifting to paying it back (i.e., higher taxes). Valuations today are signaling anemic long-term returns and rising rates are also a headwind for both income investors … and corporate margins.”

But the strategists, headed by Savita Subramanian, are not recommending that investors retreat from the market. “Our work suggests staying invested is an under-appreciated way to avoid losses, and that focusing on fundamental factors over momentum/positioning factors wins over the long-term. Quality, which is cheap and neglected, is also a good hedge against volatility.”

Keep a ‘Value Mindset’

Sonders says that investors “should have a value mindset but not put blinders on.” That doesn’t mean buying a major stock market value index, she said, but having a “focus on the actual fundamentals of growth and value for a stock.”

Sonders is not against investors choosing passive index funds, which have the benefit of low fees, and recommends a combination of passive and active investing because the latter can address the higher correlation that’s apparent now across and within asset classes as well as the wider dispersion of potential returns among stocks.

“The biggest risk for the market is speculative excess … We learned in the late 90s and early 2000 periods that speculative excess doesn’t make a lot of fundamental sense but can last a long time.”

From a more fundamental view, she noted that U.S. stock market is less overvalued today than in the fourth quarter of 2020, based on the forward price-to-earnings ratio of around 23 despite the excessive speculation in low quality sector of the market and the popularity of special purpose acquisition companies (SPACs), which are shell companies in search of investment targets.

Sonders noted she’s “not saying the market is cheap,” but she’s not concerned about valuations like she was in 2000. She expects a “pop in inflation in conjunction with a huge surge in growth,” which will also raise rates, but isn’t concerned about systemic wage price inflation.

Where Sonders Sees Value in the Market

As for where she sees value in the stock market today, Sonders said Schwab rates the financial and health care sectors as outperformers and utilities and consumer staples as underperformers over the next months.

Sonders also favors small-caps, which are “more levered to the pickup in the economy,” but only quality small-caps.

She also recommends that, in a market where speculation is so excessive, investors understand their financial and emotional risk tolerance, the latter being their “freakout point” when markets retreat: “What kind of loss can you withstand emotionally?”