Savita Subramanian on Stocks. Plus, Oil and Amazon.

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A lot of folks just look at the S&P 500 and think it looks really expensive. It's trading at, you know, 20+ times earnings depending on what measures you're looking at. If you take out those 7 companies, or if you take out whatever the mega caps, the Nifty 50, you get a valuation that is much more reasonable. It's more like 15 or 16 times.

Hello and welcome to the Barron Streetwise Podcast. I'm Jack Howe, and the voice you just heard is Savita Subramanian. She's the head of US equity and quantitative strategy at BofA Merrill Lynch. And in a moment, we'll hear from her about what to make of the US stock market. We'll also say a few words about oil prices approaching $100 a barrel and Amazon antitrust stuff. Listening in is our audio producer, Meta. Hi, Meta.

Hi, Jack.

What do you think? Start with oil and move to Amazon?

Yeah, that sounds good.

I want to try to make sense of a mini mystery here, and that is, why we're not producing more oil. Our friends at the Wall Street Journal had a story on Thursday titled Oil Is Near $100. Shale Isn't Coming to the Rescue. By shale, they mean some of these U.S. drillers that have holdings with rich shale deposits that could be setting up more wells and producing more oil. They're not doing that. The story says that the number of rigs drilling for crude has declined by 12% since the end of April, even though US oil prices are up by about $13 a barrel over that same stretch. So why would shale drillers want to produce less even though prices are rising?

Because then they work less and get more money or get the same money.

Kind of smart.

I mean, that's actually— that actually sounds like a lot of the answer. Yeah, but you're jumping ahead, Meta. I have to use some fancy words first, and one of those words is backwardation. When we talk about the oil price, there's a price that people are paying today that's called the spot price, and there are also prices they're paying for future deliveries of oil, and, and those prices trade in the futures market. And we can make a curve of the price, the price today versus what the price is expected to be in the future. And under normal circumstances, that curve is supposed to rise gently over time because you have inflation and the price of things tends to up. But right now, that's not what the curve looks like. It shows future prices for oil falling from here, significantly, in fact, over the next couple of years. And analysts call that phenomenon backwardation. Sometimes they'll use an adjective, they'll call the oil curve backwardated. And if you're wondering why they don't just call it backwards, I'm pretty sure it's because in the money management business, you have to add extra syllables so that the clients can't understand fully what you're talking about, because that makes you sound like you know something they don't, and then you can charge extra fees for it. And that's a good thing because I live an hour north of Manhattan, so I'm within the gravitational pull of the Wall Street real estate pricing center. So my home value depends on Wall Street firms being able to charge those fees. I'm getting off track, Meta, come on. Okay, so the reason the oil price is rising today is that Saudi Arabia and Russia have agreed to extend some production cuts. So investors are worried about tight supplies. Supplies don't have to stay tight, though. Shale drillers in the U.S. can increase production. But remember from past conversations we've had with, let's say, Rick Moncrieff, who's the CEO of a big shale driller called Devon Energy, that those companies are reluctant to increase production now. And he talked about how during past oil booms, shale drillers quickly increased production. Then there was a price crash and the result was a falling share price for the drillers and some losses, and shareholders weren't happy. So now shareholders want capital discipline, and the whole group has promised to show capital discipline by holding production in check. Rick also pointed out some other things to us. He said that the cost of rigs was way up, and he said if he starts setting up new rigs, let's say today, it might take 9 months or so for that production to come online. But when he looks at oil prices, the futures market, they tell him that the price is going to be lower in the future. So that's their rationale for not drilling more now. They say, we're just doing what investors have asked us to do. That creates a strange situation. As long as investors know that there's plenty of spare capacity that could be put to work, those future oil prices are going to be lower and the shape of the oil curve is going to be backwards.. But as long as the shape of the oil curve is backwards, those shale drillers might be reluctant to increase their production. B of A Securities, writing about this situation this past week, wrote, in the 3 decades that we've looked at this sector, anytime Saudi is not challenged for market share, it will defend price. In other words, if U.S. shale drillers aren't going to ramp up production and begin to sell more oil under the world market, Saudi Arabia is going to keep the price high. B of A writes, but the consequence of artificial price support is that backwardation is embedded as a permanent characteristic of the futures curve. In other words, the futures market could imply falling oil prices in the future for a long time to come, even if prices don't in fact fall. And you would think that would be good for oil companies, those higher prices, they make good money as As Meta, as you outlined earlier, I believe in your—

how did you put it in my hefty analysis that they make more money if they make less oil?

Yeah. Yeah. Prices stay high, they spend less, they make good money. They're loving it. And in fact, this is good for the cash flows of oil companies, but it might not be great for the shares. BofA writes the impact on sector valuations is modest. Tempered by a backwardated price structure where the long-dated price is the only barometer of what the market will discount. In other words, the market's looking at that oil price curve and the possibility of falling prices in the future, and so it's only willing to pay so much for the money that these oil companies are making today. Does any of that make sense? Was that too confusing, Meta?

No, I think it makes sense. Oil companies are kind of happy. Investors are kind of happy. People at the pump are pretty unhappy.

Investors would like to see share prices move higher, probably, and they're probably not going to get that right. They've done okay. The stocks, they might not get further increases right away for these stocks because everyone's cautious about the possibility of prices falling in the future, as suggested by that futures curve. People at the pump, they're going to pay more for gasoline, and that's going to do its part to elevate inflation. The inflation isn't dominated by the price of oil, but it's a factor. I got a trivia question for you. If that falling shape of the oil price curve is called backwardation, what do you think the regular shape is called where it rises? You know what you want to say. Upwardization. Oh, I thought you were going to say forwardization. Upwardization is a good guess too. The actual answer is contango. How many guesses would you have had to go through before you got to contango?

A few.

Why do they call it contango? I don't know why. Just to keep people surprised, I guess. Should we move on to Amazon?

Yes.

The U.S. Federal Trade Commission filed a long-awaited antitrust lawsuit against Amazon on Tuesday, claiming the online retailer harms consumers by keeping prices artificially high.

This past Tuesday, the Federal Trade Commission and 17 states sued Amazon alleging that it illegally wields monopoly power.

In the United States, companies don't get much bigger than Amazon, worth $1.3 trillion with more than a million employees worldwide. But now federal regulators in the United States say it got this big and this rich using unfair practices.

They say it keeps sellers stuck in its platform. They say it keeps prices artificially high. And that it hurts its competition. It is bad if it's true. The stock fell 4% in reaction to that news. For the year, it's still up more than 40%. To me, that looks like the stock market saying, we think Amazon is going to be okay. I'm not going to go into great detail about this suit. I'm not an antitrust lawyer, and this process could take more than 2 years to play out based on a suit going on at Alphabet right now. Let me just mention a few points that analysts have been making. One is that the government has not been especially successful lately suing big tech. The FTC lost a lawsuit against Meta over a virtual reality startup acquisition, and it was unsuccessful blocking the acquisition of Activision by Microsoft. There are also some widely varying ways to talk about Amazon's market share. There are charts in an FTC filing that indicate that Amazon has 82% market share of, quote, online marketplaces. But to get to a measure like that, you have to take other big retailers and only look at their online sales. For example, you'd be saying that Amazon only competes with the online portion of Walmart's business, when in fact, if you're looking to buy something, you have a choice between ordering it on Amazon or going into your local Walmart store. Amazon will argue that online penetration in the US remains relatively low, and that if you include all of the sales from these big retailers in their physical stores, then Amazon isn't such a dominant player. And that's particularly true if you look at online sales from small stores that use the service like Shopify. A colleague of mine, Tae Kim, writing for Barrons, also points out that profit margins in Amazon's retail business historically have not been exceptionally high. So the government has plenty of work ahead to prove its case. When I look at research reports on Amazon that were published later in the week, they weren't about the suit. One from Jefferies looks at Amazon's opportunity to gain market share in groceries. There's another from DA Davidson that looks at a recent management change in Amazon and interprets it to mean that It's another sign that the company is scaling back its designs in making hardware, which DA Davidson views as a good thing. The fact that after just a couple of days the lawsuit is not dominating the conversation about Amazon on Wall Street could mean that some of these analysts are too complacent about the FTC actions, or it could be a sign that Amazon is likely to come out of this just fine. Meta, are you outraged about Amazon's dominance, or do you feel like, man, they're doing a Good enough, Chad, for me.

I don't know if I'm outraged.

Your ruling will be final.

Keep in mind, I don't think it's great that one company gets that big. It makes me feel nervous.

Yeah.

Yeah. I feel like I order something, I pay not too much money, and it's at my house in like a day. It's almost spooky how soon it arrives. So I don't have a lot of complaints. I know that it's not the same if you're a seller who's looking to compete with them. You may feel a totally different way, but when I look at this, I can't help but think like, why isn't the government going after something that stinks, something that really agitates people? Why aren't they going after mattress stores or car dealerships or what else stinks? Vending machines that don't let go of the bag of chips after you've clearly put in your $1.25. Let's get to the chat I had recently with Savita Subramanian over at BofA. Last week I talked a little bit about the outlook for the US stock market, and I included some of Savita's thoughts from a recent report. So this is just going to add some more color to that. On the day we spoke, the Dow was down several hundred points. Investors were making quite a big deal about it on social media, even though the market is still up nicely for the year. Here's the conversation. Hey Savita, Jack Howe from Barron's. How are you?

Hey Jack, nice to see you.

Good to see you. Someone said on what used to be called Twitter that Great Depression was trending. I couldn't believe, I looked, I didn't see it myself, but I think that's maybe a little bit of overkill about a 400-point drop in the Dow. But what do you make of this sell-off?

We haven't even had a 5% pullback. So yeah, I think it might be premature to call this the Great Depression. You know, what we're seeing right now is just a little volatility that's actually normal. 5% pullbacks happen 3 times a year on average, and this is based on data data going back to the 1920s. I mean, I suppose what the market might be recalibrating is the idea that the Fed's not going to be cutting rates anytime soon. But didn't we already know that? I feel like that was what, you know, professional investors have been talking about that for a while. So I think that some of this might just be taking profits, recalibrating. I think what's interesting is that the best-performing sectors have been energy and healthcare, which are kind of the stagflationary duo of, you know, benefits from higher oil and inflation and defensive healthcare, which is sort of a, you know, recession-proof sector. But I'm not panicking.

Do you think we're moving toward normal? I mean, if you look at what has been selling off, does it seem sensible to you? I see some of the big tech stocks selling off and there has been a conversation around whether they had gotten too expensive? Does it look sort of orderly and sensible?

I don't know if the last 3 days look orderly and sensible. The idea of a little bit of steam being taken out of this Magnificent Seven makes sense to me. That was the one area where we had seen, you know, a little bit of, well, a lot of crowding risk, actually. In fact, what was interesting to me is that a lot of mutual funds, you know, so-called diversified mutual funds, had more than 30% of their portfolio AUM in, you know, less than 5 stocks. So that's really getting to a point where CIOs are stepping in and saying, you can't add any more to these companies. And I think that was sort of a tipping point that we saw maybe a few weeks ago. I think that sort of mini correction in mega-cap tech companies makes sense. I do think that those might be the new core holdings for the foreseeable future, and they don't look like the really scary long-duration, you know, super rate-sensitive sensitive companies. Many of them pay healthy dividends and have inflation protection from, you know, earnings being nominal. But I do think that the market was just getting way out of whack with reality in terms of just its top heaviness. So to me, the broadening out of the benchmark is what makes more sense.

We interrupt this regularly scheduled program for the emergency advertising service. Don't panic, right, Meta?

Right.

No, it's all good. It'll be done in a few minutes.

Be over before you know it.

Data is everywhere, but is it ready for consumption? Morningstar developed the language of global investment data so you have the right ingredients to help you shine. Morningstar, where data speaks.

Welcome back and back to the conversation with Savita. I want to ask you about a research note that you put out recently. The title of it is Don't Worry, Be Happy. And I want to ask you about two points in there. And one was that you feel that the, the S&P 500 could end the year higher than it is now. I do. And then the other is that you seem particularly bullish on the equal weight index. So maybe let's start with the regular index. In the face of these bond yields that are now higher than in recent memory, what has you still optimistic about the regular S&P 500?

Yeah, so I think there are a few things. I mean, one, the S&P 500 has basically bought itself some time to adapt to a higher interest rate environment. And what I mean by that is If you look at the companies in the S&P 500, they've dramatically reduced their floating rate risk exposure. So we all learned in 2008 that floating rates were risky and you should lock in long-dated, fixed-rate, low-interest obligations. And homeowners did that and corporates did that. So today we're in a kind of a better place where 85% of US homeowners have fixed-rate, long-dated mortgages. You know, floating rate risk has been cut in at least half since 2007, and close to 80% of debt sitting on corporate balance sheets for the S&P 500 is fixed rate. So that doesn't mean that it's gravy from here. But I do think that it means that companies have time to sort of adapt to this new higher rate, higher inflation environment. I think the other component for corporates is that they haven't just been sitting around kind of waiting to be smacked in the face by higher rates and inflation, they've been spending and focusing on efficiency gains. So over the last couple of years, we've actually seen companies do what they typically do when labor inflation rears its head, which is they start thinking about how to do more with less people. And I think the benefit here is that it's not just AI that could replace people, but, but companies have been spending on automation and lots of different efficiency themes over the last few years. So at some level, this tight labor market right now that's creating rampant wage inflation that the Fed is trying to cool could actually be quelled by other forces, i.e., just more efficiency over the next few years that we typically see coming out of these types of environments. So I actually feel like there's more going on to the S&P 500 and there's more optionality that companies have relative to fixed income, you know, long duration bonds, which are by definition fixed income and fixed duration. US companies can shorten their duration as well. And, and this was something that I thought was sort of interesting to see with big cap tech companies at the beginning of this year. So, Jack, if you remember back in the first quarter, I think it was, you know, all of the big tech companies did what they should have done. They admitted that they had overbuilt capacity. They, you know, they downsized their labor forces, they cut a lot of costs. And then in some cases, they did big share buybacks that basically pulled a lot of their cash return forward. And I think that is a really interesting theme going forward, is the idea that companies can actually shorten their duration risk, unlike bonds.

Yeah, that's interesting. You make the point that the two, you know, we think of them both as financial instruments, but stocks are businesses with smart people running them who can make different decisions and adjust. What about the S&P Equal Weight Index? Do I understand correctly, you have a forecast in here for the Equal Weight Index to outperform the regular S&P 500 over the next decade? Is it 5 percentage points per year, that outperformance?

In excess of the S&P.

Exactly. That's a striking amount of outperformance.

What? Yeah, yeah, yeah, yeah. Exactly. It's a big difference. And I mean, it can go a lot of different ways, but I think that what happens is either mega caps right-size and get a little bit smaller and some of the mid-cap companies in that benchmark grow bigger. And, you know, we get to a place where the benchmark itself isn't as top-heavy. But the driver for that discrepancy between returns is really valuations. And I think, you know, a lot of folks just look at the S&P 500 and think it looks really expensive. It's trading at, you know, 20+ times earnings depending on what measures you're looking at. If you take out those 7 companies or if you take out whatever the mega caps, the Nifty 50, you get a valuation that is much more reasonable. It's more like 15 or 16 times earnings. 16 times. So I think that that's the crux of it, is that when you think about long-term gains of equities, generally valuation is one of the most important and predictive drivers of long-term returns. And right now, the valuations for the equal-weighted benchmark are that much more attractive than the valuations for the cap-weighted benchmark. So that gets us to a pretty hefty excess return of the equal-weighted versus the cap-weighted benchmark. And then, you know, I think on top of that, when you think about the average company company in the S&P 500, there are areas of the market that have grown lean and have been denied capital for, you know, the full cycle. If you think about industrials or cyclical old economy companies, we haven't necessarily seen the lending channels opening up for energy companies or financials, but these companies have actually learned to survive without capital and are now relatively inexpensive, but in a much more attractive position from a balance sheet.

Standpoint. And you get more of those kinds of companies pound for pound if you're buying the equal weight index. Have I got that right? Absolutely. If you're buying the regular cap weighted index, you're getting that heavy weighting in like artificial intelligence and big tech and all, all this kind of stuff. Yes. So you think that the industrials, the banks, some energy companies are, are poised to do a little better here?

I do. I mean, I think that we're in an environment where our economists are saying, You know, we've been calling for this recession for 2 quarters away for such a long period of time. And now it's kind of morphed into this softer landing. U.S. consumers look okay, gainfully employed, real wage growth just inflected positive. So, you know, consumers have money to spend. That is, you know, they're making more than what they're paying at the grocery store. So I think those are all positives for the economy. Yet we have this setup where the only stocks that investors believe can survive over the next year are mega-cap tech companies. And I just think that's, that's wrong and it's overblown and it's far too draconian, especially in the face of what we're seeing on the manufacturing side. So when you think about fiscal stimulus and the Inflation Reduction Act and the CHIPS Act, there's a lot of money that's been earmarked for spending on infrastructure over the next 5 years, over the next 10 years. And that's generally accompanied by pretty good economic growth. We haven't seen a real CapEx cycle in a while, and I think we kind of forgot what it looks like. But it's usually pretty bullish for the economy. It's bullish for consumers, it's bullish for jobs. And I think those are the areas that could actually do pretty well over the next cycle. But they've been sort of left for dead in this race to own the best AI plays. In the S&P. Meanwhile, I have to say, I think a lot of these old economy companies could become AI plays in that if you think about labor efficiency at a bank or an insurance company or a legal services company, there is so much efficiency that can be gained by replacing a lot of these rote processes with algorithms. And I think that's another theme.

That's hard to figure out. It's interesting that you say that. There are the companies that do the AI, right? The NVIDIAS and so forth. Right. Then there are the companies that, you know, maybe they're just sitting on a pile of old data that could be put to better use. Maybe they could have some costs that could be reduced. How do you go about thinking about the biggest AI beneficiaries? What kinds of industries and businesses would you be looking at?

Yeah, so I leave that to our experts and I think that AI is part of it, but I'll give you some examples. Like if you look at restaurants, we've already seen kitchens of today, you know, kind of very different in terms of the number of people versus kitchens of the past. So that's one area where we've seen automation already. AI is obviously, you know, the obvious themes that everybody talks about are call centers, help desks, etc. You know, paralegals and sort of number crunching and lots of big kind of rote processes. But I think that beyond that, there are probably things that you and I aren't even aware of or that nobody is aware of at this point that can be replaced with processes, not just AI, but efficiency writ large. And, you know, I think that what's interesting is US companies got really lazy when it came to labor efficiency over the last 10 years. So if you look at the dollars generated per worker across S&P companies, we saw this boom in efficiency from 1985 to around 2005 or thereabouts, and then it just stalled out and we saw very little efficiency gains being made. And I think one of the reasons was that in 2001, China joined the WTO and we saw disinflationary forces from you know, moving things to cheaper areas of the globe. So there was no need to think about expensive labor if you could move your whole plant to a cheaper area. And then on top of that, you had cheap capital which went to, you know, zero, and you could just do levered buybacks all day long to generate earnings growth. So you could be lazy for the last 10 years. And what was interesting is that over the last 10 years, we've seen stocks trade at a higher risk premium than the period where we were actually seeing major efficiency gains. So I think that what's happening is we're back to a more, you know, an environment where companies have to work to generate earnings, but investors are actually willing to pay a higher multiple for stickier, operationally driven efficiency gains rather than just fake earnings growth.

And just so I understand on earnings, we've had a couple of quarters where earnings growth hasn't been wonderful. What's the trajectory look like for here for US earnings, do you think?

Yeah, so I think that barring, you know, a full-fledged recession, again, not our base case, barring a scenario where companies, you know, I think that consumer confidence, the way it would be roiled is if we saw massive job losses. So assuming we stay see relatively benign labor markets, no massive layoff cycle, demand remains relatively steady, kind of a run rate of what's happening right now. Our view is that earnings could actually pick up over the next 12 to 24 months. We, we think that second quarter is a trough in earnings growth. And the reason is, if you look at companies, they've been able to maintain margins, they've cut a lot of costs, If we do see sort of a, you know, an environment where inflation is now manageable, the Fed has bought us some latitude. We know what the world looks like going forward. We know we're off of zero interest rates. We kind of understand what the Fed's mantra is at this point. Our view is that companies can actually plan. We have more visibility around the future. We still have a lot of capital earmarked for spending over the next several years. From not just fiscal stimulus but other projects where we've seen ground broken, nearshoring, you know, all sorts of other themes that are taking place in the US outside of the coasts of, you know, Silicon Valley and New York. So I think that there's enough bullish momentum and economic momentum taking place here to keep this thing going. I think that the question from here on out is jobs. So consumers typically don't stop spending until they lose their jobs. And then I think that, you know, inflation, if the Fed manages to keep inflation contained, if we don't see oil prices do some kind of super spike, that would keep us relatively sanguine on the, on the economy and on earnings growth. You know, again, I think the next story for margins might not be cost cutting or, you know, globalization or cheap capital, but it might be more about efficiency gains and, kind of stickier operational improvements.

That's most helpful. Thank you. I feel better about my stocks. We're speaking on this piece of video conferencing software, and there's a new button on the bottom I see. It's called AI Companion. I was going to click it earlier, but I'm a little afraid to find out. Maybe it's going to ask smarter questions than I ask or something. I don't want to know.

That's right. That's right. You and I can be replaced.

Not you, but me I'm concerned about. Always great speaking with you, Savita. Thanks. Take care.

Take care.

Thank you as always, Savita, and thank you everyone for listening. Meta Lutzoff is our producer. Subscribe and rate and blah, blah, blah. Meta, let's do a plug for our friend Andy Serwer at Barron's. He has a video series that's now an audio series. How would you describe this?

Yeah, so Andy Serwer has a video series on Barron's.com. And now it's expanded into a podcast series. It features conversations with top CEOs.

Watch it with your ears. How's that for a tagline? That's— we'll work on it. What's the series called?

What should people look for? At Barron's, available in Apple Podcasts, Spotify, or wherever you listen to podcasts.

Very nice. See you next week.

Data is everywhere, but is it ready for consumption? Morningstar developed the language of global investment data so you have the right ingredients to help you shine. Morningstar, where data speaks.