Bond investors are chasing the past

liz_ann_sonders.top.jpg By Mina Kimes, writer


(Fortune) -- When Liz Ann Sonders declared last June that the recession was over, her call was met with widespread derision.

"I was lambasted for those comments," says Sonders, the chief investment strategist at Charles Schwab. "It was an out of consensus view, and not very popular."

Now, of course, the consensus among economists reflects Sonders' outlook back then: The recession did end last summer, when most indicators of economic health began to reverse their declines.

It didn't feel like a recovery at the time because of the high unemployment rate, says Sonders, which typically lags other indicators. "Recoveries aren't announced when you have traction behind you," she says. "The bottom is when the economy stops declining."

So what does Sonders, who oversees economic and markets analysis at Schwab, foresee now that the recovery is underway? She's still more bullish than most -- but she's skeptical about bonds and emerging markets. Below, an edited excerpt from her interview with Fortune.

After an initial setback earlier this year, the market seems to be roaring again. Can that possibly continue?

I think the stock market is looking at a choppier year -- certainly nothing resembling the 75% rally we've had since March 2009. That said, the path of resistance is still up. I continue to think that the consensus for the economy is too low, and I'm quite optimistic that the recovery is not only real, but will look something more akin to the recovery in the early 80's.

Someone asked me a question the other day: If I were to ask you whether we would get a melt-up or a meltdown, what would it be? I think there's a much greater likelihood of a melt-up.

What's driving the recovery?

Economic indicators continue to perform better than the skeptics believed they would. There's a V-shaped nature to them that, amazingly to me, people still pooh-pooh.

What's helping us is the phenomenal surge in global production. If you look at it, it's almost unbelievable -- I don't even know if you could call it V-shaped, because it's a straight line down and a straight line up. That helps to explain why there's a bit of a bifurcated economy in the U.S., with large and small companies. The big companies tend to be more global in nature and can take advantage of this boom, and they also have easy access to capital markets. The caveat to my robust optimism about the economy is that it's certainly worse for small companies.

What about unemployment? Jobs data is still mixed.

The unemployment rate looks ugly, but it's the ultimate lagging indicator. We've never had a recovery begin after unemployment peaks. Intuitively, people have it backwards -- they think, how could the recovery begin if we still have high unemployment? All of the leading indicators stack up in favor of job gains. Corporate profits are on a tear right now -- that's a necessary condition for hiring.

The other thing is that we're in a catch-up phase. Job losses went well beyond what the decline in the economy suggested. At the time of the greatest uncertainty, the expectation was that this was Armageddon. What you're now hearing from companies is that they not only cut to the bone, but into the bone. We should have seen payrolls decline by 4.2%, but instead we got 5.9%.

So companies over-fired.

Sure. That's why some notable big companies have come out and said they're ramping up hiring. But as they see things improving, companies are not inclined to hire en masse -- they'll ask their workers to do more. They've worked their inventories down to a low enough level where they have to start rebuilding them, which kicks [them] into job creation.

A lot of your historical analysis calls for reversion to the mean. But isn't it possible that we're living in the so-called "new normal," and things won't go back to previous levels?

Even as an optimist, it's hard for me to imagine a scenario that gets unemployment down to something that feels good -- under 5%. You're in lala-land if you think that's coming.

I do think we'll revert to the mean in housing, but you have to appropriately cross out the bubble period.

Do rising bond yields pose a risk to the recovery in the market?

Classic economics textbooks teach you that rising yields are bad for stocks. But since the late 90s, we've actually been in an environment where yields and stock markets move together. The last two times that happened were in the 1950's and the period during and immediately after the Great Depression. The common factor for these periods is that we were coming out of a deflationary environment. What happens when you're coming out of deflation is that when yields start to go up, it reflects a strong economy.

So we're still in the sweet spot, where rising yields reflect stronger economic trends, not a big risk of inflation reigniting any time soon. It's a good environment for stock prices. I don't believe we'll stay there for perpetuity, though.

What does the rising dollar mean for US stocks?

Over the last couple of years, the dollar and stocks have moved inversely. In the fall of 2008, the global economy and markets started imploding, and [buying] the dollar was a flight to safety. Then in March 2009 when the market bottomed, investors were going back into riskier assets and the dollar started to underperform again.

Over the last few months, that's changed. People ask: What do you make of the fact that the dollar and stock market are going up simultaneously. isn't that odd? Actually, it isn't: The two years in which they moved inversely were the anomaly. Normally, they move in tandem.

In your latest webcast, you sounded more bullish about U.S. equities than emerging market stocks. Why?

In emerging markets, the prospects from an economics perspective look phenomenal. But investors need to be mindful of stretched valuations and overbought conditions. If you made profits in emerging markets and it represents an outsized portion of your portfolio, it may be appropriate now to pare that back in favor of U.S. equities.

Are you concerned about bonds? Investors still seem to be pouring money into fixed income funds.

Investors are doing what they do well, which is chase past performance. So sure enough, when there were peak inflows in bond funds, you had outperformance by stocks.

As of the first quarter of 2009, we had a 20-year period in which bonds outperformed stocks. The last time that happened was the 1940's. Since we hit peak outperformance, you've got the bond market trending down. It's a classic reversion to the mean. Unless I'm dead wrong about the economy, it's hard to envision a scenario in which yields turn sustainably down. To top of page

Frontline troops push for solar energy
The U.S. Marines are testing renewable energy technologies like solar to reduce costs and casualties associated with fossil fuels. Play
25 Best Places to find rich singles
Looking for Mr. or Ms. Moneybags? Hunt down the perfect mate in these wealthy cities, which are brimming with unattached professionals. More
Fun festivals: Twins to mustard to pirates!
You'll see double in Twinsburg, Ohio, and Ketchup lovers should beware in Middleton, WI. Here's some of the best and strangest town festivals. Play
Overnight Avg Rate Latest Change Last Week
30 yr fixed4.25%4.27%
15 yr fixed3.23%3.21%
5/1 ARM3.37%3.37%
30 yr refi4.19%4.36%
15 yr refi3.18%3.17%
Rate data provided
by Bankrate.com
View rates in your area
 
Find personalized rates:
Company Price Change % Change
Bank of America Corp... 15.52 0.07 0.45%
Apple Inc 100.57 0.04 0.04%
General Electric Co 26.36 0.31 1.19%
Intel Corp 34.50 0.16 0.47%
Staples Inc 11.32 -0.30 -2.58%
Data as of 4:01pm ET
Index Last Change % Change
Dow 16,979.13 59.54 0.35%
Nasdaq 4,526.48 -1.03 -0.02%
S&P 500 1,986.51 4.91 0.25%
Treasuries 2.43 0.02 0.87%
Data as of 10:50pm ET

Sections

This month, Delaware became the first state to pass a law giving heirs the right to access the online accounts and assets of someone who has passed away. More

Median income is up 3.8% since 2011, though it's still down since the economic recovery began in 2009. More

Small business owners say the economy is still their biggest challenge, which keeps them from expanding and hiring, according to a CNNMoney-Manta survey. More

This month, Delaware became the first state to pass a law giving heirs the right to access the online accounts and assets of someone who has passed away. More

Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.