Charles Schwab Chief Investment Strategist Liz Ann Sonders on Wednesday urged caution about market speculation and the potential impact of tariffs. She suggested investors take profits in lower-quality small-cap stocks that have been outperforming peers with stronger corporate earnings.
"It's the weaker companies from a profitability standpoint that are performing best within the Russell 2000," she said during a conversation with Hedgeye CEO Keith McCullough during his firm's virtual investing summit.
Fifty-seven percent of the Russell 2000 is profitable, 41% is not profitable and 2% are companies from which accurate earnings data are unavailable, she noted.
"You have more than twice as strong performance by the non-profitable cohort than you do the profitable cohort, which also, by the way, explains why the Russell 2000 is so significantly outperforming the S&P 600," a small-cap index with a profitability filter, which the Russell doesn't use, said Sonders.
"I think you want to fade that non-profitable segment of the Russell. I think you want to lean into up the quality where there's actual profits. You may lag if you continue this speculative theme to this market, which has baskets like non-profitable tech and quantum and drones and the meme stocks doing well," she said.
"I think any meaningful hit to the market, I think you're going to see a disproportionate hit there. Especially if some of the hype themes start to fade for whatever reason. So I'd not, maybe not steer clear, but I would be mindful of taking profits in that lower quality, non-profitable segment down the cap spectrum," the market strategist said.
Sonders also voiced concern over speculation more broadly.
"Levered ETFs only represent about 1% of all AUM for ETFs, but they represent 12% in terms of recent activity and an even higher share of new offerings in the past several months. So I think there are lots of places we can point to to suggest speculative froths. The problem is figuring out when the music stops," she said.
Small-cap stocks should benefit from Federal Reserve easing, according to Sonders.
"The Fed is in easing mode now and that accrues all else equal to the benefit of smaller companies. So I think it's a beneficial combo right now of the easing cycle on the part of the Fed, assuming it's a cycle and not sort of a one- or two-off, and a better earnings trajectory that I think is supportive of small caps," she said. "But I'd stay with the earnings, the companies that actually have earnings or have some prospect of, earnings."
Tariffs and Tax Cuts
Addressing the economy, Sonders suggested tariff headwinds are not over and that any tailwinds from tax cuts will act more as an offset.
"I disagree with the notion that tariffs represent just a one-time price level reset," she said.
"It's been fits and starts, escalations, de-escalations, announcements, delays. So the nature of how they've been rolled out is anything but one-time in nature. And I think because a lot of the front-running that happened with companies in advance of tariffs taking effect that allowed companies to build inventories at a low cost basis, giving them some calendar wiggle room in terms of their pricing strategy."
Companies are eating two-thirds of the tariff hit now although it's not yet hitting profit margins to a meaningful degree, Sonders suggested. "But I think that is set to shift where there's going to be more pass through," which could cause "some demand destruction."
Sonders sees bifurcations in the economy and market, such as goods affected versus unaffected by tariffs, or inflation in wants versus needs, or earnings. "The fine-tooth comb is probably one of the most important tools to have right now," she said.
The strategist also noted the potential for a negative wealth effect on the economy.
While there are differences between the AI boom and the late 1990s dot-com bubble, a recession probably wouldn't have been declared in 2001 were it not for the equity market crash, she said.
Total value of all U.S. publicly traded stocks as a share of gross national product hit a record high at the time, and "we're at even higher records there. So what I do wonder about is the circularity and the ripple effects when we eventually get another bear market in stocks — that's not an if, it's a when. And whether we see that as a feeder into the economy a bit more directly," said Sonders.
"I just think that that is something that we maybe should at least have in the back of our mind."
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