Why the S&P 500 Is Looking Wobbly

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My contention is that I think this is going to be a really different year in terms of market leadership. And if it's different, that means that the S&P 500 might not crush it again, and it might lead leadership to other areas.

Welcome to the Barron Streetwise Podcast. I'm Jack Howe. The voice you just heard, that's Savita Subramanian. She's the head of US Equity and Quantitative Strategy at BofA Global Research. We heard from Savita on this podcast just under a year ago. This time around, she's not as bullish on the US stock market, but she does have some ideas on what to favor and what to avoid. I mean, personally, I recommend favoring the ones that go up and avoiding the ones that go down, but we should probably hear what Savita says. Listening in is our audio producer, Meta. Hi, Meta.

Hi, Jay.

My wife bought me a rug for the office at our new house. Is it cutting down on the echo? How are my acoustics right now?

I think it sounds really good. I think it sounds much better.

Nice resonance there.

Beautiful.

I must say, the rug is appallingly ugly. I thought at first it was an April Fool's Day joke, and then I thought maybe my wife is upset with me, but it turns out she says it's just a modern design. It looks like if you took all the stains in the history of carpeting and if they got together for like a stain reunion on one rug, that's what this looks like. And on the first day that we had it, my dog Ginger Don't worry, she didn't pee on it. She had a playdate with her friend Paprika, and Paprika peed on it. Am I popping my P's in this microphone, Meta?

No, you're good.

All right, well, Paprika peed on it, and the house has nothing but easily moppable wood and tile floors everywhere except for one rug under my feet. But the good news is we cleaned the rug and it's so ugly I can't even tell where the stain is. And Meta, I have other good news from this past week that's even more important than that news. I just booked my first flight since before the pandemic. It's for a family trip this summer, and I assume vaccinations will be widespread by then. And second, I got an appointment for a vaccine shot just a couple of days from now. Where I live in the state of New York, they said, anyone over 30 is now eligible, and I'm safely over 30. I'm so far over 30 that if you took the number of years that I'm past 30, you could make another adult with those years. So I refreshed CVS's signup website about 650 times until an appointment showed up, and I grabbed it. Now, if I'm getting a vaccine and booking flights, that means many of us are, and that means life will be more normal soon. And there's still a lot of room for improvement in the economy. On this podcast, I've mentioned the Goldman Sachs Reopening Index several times over the past year. It tracks lockdown activity like video gaming and reopening activity like travel booking to get a sense of where we are on the road back to normal. Back around the end of last summer, the index hit 5 out of 10, meaning we were halfway home. But as of a week ago, it was still at 5. Progress has been slow, and hopefully that's now changing. One challenge for investors is that the stock market is already anticipating the economic reopening. Lockdown stocks like DoorDash for food delivery and Zoom for video conferencing, Teladoc for home health, Peloton for home fitness— those are all way down from their highs. But reopening stocks have soared. In a column last week on European stocks, I pointed out that JP Morgan tracks baskets of reopening stocks for different regions. And that its U.S. basket had recently returned to its pre-pandemic high. Its basket of reopening stocks in Europe was still around 20% below its pre-pandemic high. Maybe that's partly because the U.S. is off to a strong start on vaccines, but maybe it's also because a lot of the good news for U.S. stocks is priced in. To learn more about what that might mean for investors, I checked back in with someone we heard from back in May of last year. Hi, Savita, it's Jack Howe from Barron's. How are you?

Hi, Jack. How are you?

Doing well. Savita Subramanian is the head of U.S. equity and quantitative strategy at BofA Global Research, part of Bank of America. And she was laughing because there were problems with the internet connection where she was, so she had to MacGyver a fix using her cell phone. It was impressive. I didn't tell Savita about paprika and my new rug because she had enough to worry about. When we last spoke with Savita back in May, the market was recovering and getting more expensive, but she recommended to stick with stocks. She said there's not much of a correlation between how expensive the market looks based on earnings and how much it returns in the short term. There's an excellent correlation between valuation and long-term returns, So Savita had told us to expect average returns over the coming decade to be lower than what we're used to, say 6% a year. Of course, the U.S. stock market has rocketed higher since then, so you'd expect Savita to turn a bit more cautious on stocks, and she has. Her target for the S&P 500 is 3,800 by year-end. That implies a decline of several percent from the market's recent level. But at the same time, Savita is quite bullish on the economy and company earnings. I asked her to explain that contrast, why she's more confident about the economy than about near-term stock returns.

You've got two things going on. You've got this bull market in US large-cap stocks that's basically crushed every other theme outside of bonds over the last 10 to 15 years. But then you have what, what looks like a very different market cycle where leadership is likely to be potentially driven by a pickup in inflation, which we haven't seen for a very long time. You know, a move from a paralysis in the global economy to a very quick start of the services sectors and a lot of the areas that have been just halted by COVID. So my contention is that, you know, I think this is going to be a really different year in terms of market leadership. And if it's different, that means that the S&P 500 might not crush it again and it might cede leadership to other areas.

Savita says that for large company indexes like the S&P 500, returns over the past decade have been dominated by what are called secular growth companies. These are companies that are disrupting industries, often using technology. Think Amazon and Netflix and Tesla. These companies have grown so large that they're overshadowing cyclical growth companies like manufacturers that make more money when the economy picks up. Savita says that investors who want more cyclical exposure now that the economy is picking up might have to look to indexes of smaller companies or to other markets. In the U.S., she also says it's time to shift from companies that trade cheaply because they're troubled to ones that trade cheaply because they're going to generate a lot of money as the economy recovers. To do that, she thinks investors should stop looking for companies with low prices relative to book value, or the value of stuff they own, and start looking for ones with low prices relative to their current and projected cash flows.

In the early stages of an economic recovery, you tend to see these so-called junk rallies or dash to trash, or, you know, there's all sorts of different terms for it. But really what it means is, you know, the stocks that were about to go bankrupt tend to do the best in that sort of disaster-averted type of scenario. But now where we are is a more mature point in the cycle where we're starting to see some inflationary pressures erode into margins. You know, companies differentiate between just survival and, you know, how they're going to do going forward. And I think that's where you want to get a little bit more nuanced. And instead of just looking for low-priced, super cheap stocks on price-to-book, it makes sense to shift to cash flow-based measures.

Meta, I'm going to shift the conversation briefly from stocks to bonds. You might want to play some fixed income music.

What kind of a credit rating are we looking for?

You know what? We better keep it AAA. So I asked Savita about bond yields. Treasury yields have risen since the beginning of the year. A lot of investors are wondering how high yields would have to climb before bonds begin tempting investors out of stocks? Now, Savita says the 10-year Treasury yield would have to reach 1.75%, and that's noteworthy for two reasons. It's one of the lower answers I've heard to that question, and it's close to where we are now. Here's Savita.

The S&P 500 dividend yield right now is about 1.5%. If you're getting more than that on a risk-free asset, that calculation for an income-oriented investor makes it much easier to move back into the fixed income markets, which is a more traditional source of yield. And yes, I do think bond yields can move higher from where we are today. In fact, our forecast for the 10-year is above 2%.

Savita is bullish on bank stocks and not just for the reason that other investors have warmed to bank stocks recently. Most investors like that if longer-term yields are rising faster than short-term interest rates— that's also known as a steepening of the yield curve— it's a good sign for bank profits. That's because banks collect interest on longer-term loans while paying interest on short-term deposits. But Savita likes that banks appear financially stronger now than they have in the past. And that their dividend payments are low relative to their earnings, which means payments have room to grow and that investors haven't yet given them enough credit for that.

The good news about financials is that even if we don't see a robust economic recovery, even if we don't continue to see the yield curve steepen, the sector itself is actually higher quality with more stable earnings and a better ability to continue to pay a dividend. Than many of the other cyclical higher dividend yielding sectors that are in the S&P 500.

What about all this pent-up demand I keep hearing about?

I think they have money to spend. I think they want to spend.

When it's safe to go outside and people want to go, they're going to run to go to the movies.

There's a tremendous amount of pent-up demand for travel. So when we finally beat this thing, the airlines will be clamoring for new planes.

All of that is pent-up demand.

There is a lot of pent-up demand.

Eventually get the vaccine and you're going to see pent-up demand and people are going to want to go back.

It's been so long since we were all out and about that we're supposed to have a lot of pent-up demand, but I wasn't the outest and aboutest guy before the pandemic, and I'm not sure how pent-up my demand is. I'm looking forward to maybe a family trip or two, maybe some restaurant meals, but I definitely don't need more stuff. Metta, I talked myself out of buying a new Shop-Vac this past week. I mean, the one I have is pretty good, and I'm not really a frequent Shop-Vac'er. Plus, I already have a stick vac, a canister vac, a robo vac, a handheld vac, and a central vac at the house. I think I might be over-vac'd, if anything.

I think I'm under-vac'd, because I don't know what most of those are.

Now, Savita says investors should shift from focusing on consumers buying stuff to thinking about companies buying stuff. In the accounting world, that's called capital expenditures or CapEx, and companies have pent-up demand for it.

Here's Savita. So consumers really didn't stop spending on durable goods in 2020. So our sense is that, you know, the pent-up demand really isn't in consumer space, especially consumer goods. You know, potentially we see a big uptick in consumer services. But I think that if you look at corporations, corporations haven't really spent on investing in their own businesses, building out capacity for, you know, over a decade now. All we've seen companies spend on is technology. Now we're finally at a point where it looks like the economy is getting better. Capacity utilization is getting a little bit tighter. So companies might need to spend in order to meet the demands of consumers.

Consumers. One last thing, Savita shared an interesting point on ESG investing. That stands for environmental, social, and governance factors. It refers to investors sizing up companies not just on how much money they make, but also on whether they're good citizens in the global economy. I don't spend a lot of time focusing on ESG issues, not because I don't think companies should try to be good, but because. It's a well-covered subject and I find some of the ethical scorekeeping confusing. We did touch on ESG on this podcast last July when we spoke with the CEO of cigarette maker Philip Morris about his efforts to win over ESG investors. Companies that can do that stand to benefit from a flood of investor cash that's been pouring into ESG mutual funds. Along similar lines, Savita says oil drillers and other energy companies might be headed for an ESG upgrade, and technology companies just the opposite.

Tech isn't as green as it seems, and energy isn't as brown as it seems. Online retailers, while they don't have physical store presence, they do have this really taxing delivery system that takes up a lot of emissions.. So I think that when you look at a tech company, the asset-light nature of these companies really renders them attractive on the most obvious metrics of, of direct emissions. But they're actually much more costly from an emissions standpoint than a lot of the more traditional carbon-intensive or commodity-oriented sectors. Then when you step back and you look at energy companies, They look awful on direct emissions. But I think the good news is that these companies realize there's a problem and they're starting to reinvent themselves. And I think that, you know, from a bang for your buck perspective, if you're an ESG-oriented investor, why pay up for a tech company that might not be as green as it seems? And why not buy some of these companies that are really aggressively planning to clean up their act? And are meeting their goals in terms of becoming carbon neutral.

How about a listener question, Meta?

Sure. We got one from Sonny.

He's calling from Jackson, Tennessee. Hi, Jack and Meta. I've been a Barron's subscriber for over 15 years. I love the podcast. I occasionally learn something, but I mainly listen to it for all the jokes and the humor. My question is, for international investing in foreign stocks, a lot of times you hear that it is better to buy an actively managed fund versus just a passive index. What is your view on that? Is there any research out there that shows that for international investing in foreign stocks, do the index— low-cost indexes perform as well as actively managed funds? Thanks again. And by the way, I was kidding about the jokes. I do learn a lot from your podcast and appreciate everything you put out there every week.

Thank you. Thank you for your question, Sonny. For folks who don't know, index investing refers to tracking a set basket of stocks, often with very low fees, while active management uses stock pickers often with higher fees, to try to beat the same markets that the indexes are tracking. I'm not aware of research that conclusively proves which markets are best for index investing and which favor active management, but I'll give you two quick thoughts on the subject. First, I think index investing is at its best when used for developed markets and large companies. The S&P 500 in the U.S. is a good example of both. Indexes are also good for getting low-fee exposure to big companies in Europe and Japan. Things get trickier when it comes to small companies. Compared with large companies, a much higher percentage of small companies lack profits. Also, small companies tend to be much less widely covered by Wall Street analysts. Those aren't necessarily bad things. They could be opportunities. But I think it suggests the sort of high variation of returns that gives a professional stock picker a good opportunity to earn his or her keep. When it comes to international markets, some have one or two giant companies that export worldwide and many much smaller companies that serve domestic customers. For example, if you buy an index fund that invests in South Korea, close to one-quarter of your exposure will likely be to a single company, Samsung, If you buy an emerging markets index fund, nearly two-thirds of your money could be in three markets: China, Taiwan, and Korea. That's fine if that's what you want, but an active manager can spread funds more broadly among markets and target less-known companies that give exposure to customers in those markets and not just customers in the U.S. and Europe. If the bulk of your investment dollars will be placed in large company index funds in developed markets, That can help to keep overall fees down, even if you spend a little more for active management when it comes to small companies and emerging markets. One other point: over the past decade, the S&P 500 index has trounced the performance of large company stock pickers in the U.S. That has led people to believe that with index investing, not only do you get much lower fees, you also get much better performance. But be careful with that assumption. Part of the theoretical basis for index investing holds that it's not possible to reliably beat the stock market. If that's true, active managers who try to beat index funds should fail on average by an amount equal to their excess fees. In other words, if index funds charge a quarter of a percent, And if active managers charge a full percent, and if stock picking is futile, then active managers should underperform by 3/4 of a percent on average. They shouldn't underperform by 2 or 3 percentage points on average. Doing that poorly is basically a skill of its own. I've used this illustration before. There's a 2003 movie called The Cooler, William H. Macy plays Bernie Loots. Yes, yes, yes. Tell Bernie to get over to table 6. Bernie's so unlucky that a casino uses him to cool off any gamblers who go on hot streaks. People get next to me, their luck turns.

This is one of your coolers?

He's the best. In the real world, of course, coolers don't exist. People don't have innately good or bad luck. Actively managed mutual funds have been underperforming the S&P 500 by far more than the amount of their excess fees for over a decade, so either it's an industry of coolers or something other than a lack of stock picking ability explains it. Maybe it's the outperformance of large secular growth companies that Savita at BofA mentioned earlier. And maybe all the cash that's flowed into index funds has bolstered the performance of those companies. Maybe ultra-low interest rates have played a role. The point is, although I think index investing is a good idea for long-term exposure to big companies in developed markets, I wouldn't count on index funds to beat active managers by quite as much in the future as they have over the past decade. I wouldn't even be surprised to see the pendulum swing back in favor of active managers, at least temporarily, with the Coolers going on a hot streak of their own. Thank you, Sonny from Jackson, Tennessee, for sending in your question, and everyone, please keep the questions coming. Just tape on your phone, use the voice memo app, and send it to jack.how@barons.com. Thank you for listening. Meta Lutzoff is our producer, and Paprika helps with the interior design. Subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen to podcasts. If you listen on Apple, write us a review. If you want to find out about new stories and new podcast episodes, you can follow me on Twitter. That's @JackHowgh. Meta, did you get me verified? I have a blue check next to my name now.

Did you make that happen? I can't take all the glory, but I did help, I think.

Can you get my fiscal interpretive dance videos noticed on TikTok?

No, actually, our employer has asked me to actively try and remove those.

See you next week. At CLA, we're in your corner and on it. We coach tax strategies and Little League first base. We help you adopt AI data tools and we adopt Rescue's named Buddy. We walk your factory floor and jog the local 5K. Day, though sometimes we walk that too. Wherever you're coming from, we're right there with you. Wherever you're going, we'll get you there. CLA—CPAs, Consultants, and Advisors.

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