This Bull Hasn't Given Up Hope

Schwab's Liz Ann Sonders explains why this might be the best of times for stocks

With the major market indexes down between 5% and 10% so far this year, it's hard to be bullish. But that's not the case for Liz Ann Sonders, chief investment strategist at Charles Schwab & Co. (SCH ), who predicts a rally. She gave her reasons in a recent interview with Associate Editor Toddi Gutner.

To what do you attribute the decline in the stock market in the past seven weeks?

Investors have been more concerned with inflation, the economic slowdown, and what the Fed has been doing vis-à-vis interest rates than the healthier fundamentals of earnings and valuation. This environment is similar to 1994, when the Fed was raising interest rates. Once the Fed stopped, the market rallied 40%.

When do you think the Fed will stop raising rates?

It's difficult to pinpoint an exact time, but I think the Fed will stop a lot sooner than people think. In general, the consensus thinks the Fed will increase Fed funds up until about 4%. We think it may stop closer to 3% -- and we're already at 2.75%. Inflation is not as big a risk as it appears. While inflation has picked up, it is still at very low historical levels. Money-supply growth is slowing, and commodity prices have come down off their highs. As a result, I expect a mild economic slowdown. I don't think we're going into recession, but I do expect a slower patch.

What does that mean for stocks?

The market tends to do best under a steady economic growth environment -- it doesn't like recessions or economic growth so fast that interest rates rocket. You know, the Goldilocks economy is best -- not too hot and not too cold.

What is your near-term forecast?

A 10% rally in the short term is not too bold a forecast, and here are two reasons.

One is investor sentiment. A survey by the American Association of Individual Investors recently reported that more than 50% of investors were bearish. It's rare that it gets that high. When that indicator has gone to such extremes in the past, it has led to subsequent rallies. When expectations get so low, the market has a tendency to exceed those expectations. So there is an opportunity for a rebound, and there's a lot of cash sitting out there to make it happen.

The other is valuation. There have been positive earnings surprises, but stock prices are falling. So despite better earnings, the market has become cheaper.

What kinds of stocks are you favoring?

We have a bias toward large-cap stocks -- generally they do better when the economy slows. We like the energy, health-care, and consumer staples sectors. We like energy because the earnings outlook is better than any other sector in the market. Our interest in health care and consumer staples reflects our view that their defensive characteristics will be rewarded in a choppier market.

What kinds of stocks are you avoiding?

The financials and consumer-discretionary sectors such as retailers and auto makers. In the case of the financials, we are at a point in the interest-rate cycle at which this sector underperforms the market. We are avoiding consumer-discretionary stocks because higher energy costs are hurting the consumer's ability to spend.

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