Willy Walker:
Good afternoon and welcome to another Walker Webcast. It is really nice for me to be back in our studio and actually be doing live conversations after the past four webcasts being taped from our summer conference in Sun Valley, Idaho, back in July. I hope everyone enjoyed those recordings in the Walker Webcast over the last month, but I am really excited to have Liz Ann Sonders back, or not back with me, here for the first time, but on the Walker Webcast today. Liz Ann, let me do a little quick bio, and then we'll dive into the markets and what you're seeing and all that.
Liz Ann Sonders is Chief Investment Strategist at Charles Schwab, where she is responsible for providing investment insights, market analysis, and economic commentary for individual investors, advisors, and institutional clients. She is one of the most widely followed voices in financial markets and is recognized for her ability to translate complex economic and market developments into practical investment guidance. She has 107,000 followers on LinkedIn and 767,000 on X. Her X feed is exceptional to those of you who like insightful macro data as I do.
Before joining Charles Schwab in 2000, Sonders held senior investment and research positions at several major financial institutions. Throughout her career, she has focused on macroeconomics, market cycles, equity strategy, investor behavior—we're going to talk about that a bunch—and portfolio construction. Her analysis is frequently cited by major financial media outlets, and she's a regular guest on CNBC, Bloomberg, and other leading business networks. She is a graduate of the University of Delaware and is an MBA from Fordham University. Liz Ann, first of all, thanks for joining me.
I've heard you talk about the markets as a jigsaw puzzle, and you ask people, what's the most important piece to a jigsaw puzzle? And I love your response to it, but many people say we've got to go with the corners, or someone else says that we've got to go with the final piece that completes the picture. What's the answer to what the most important piece to the jigsaw puzzle is? And then as you answer that, if we were to look out five years from now rather than five quarters, what structural change to the U.S. economy do you think investors are most unprepared for? How does that picture change?
Liz Ann Sonders:
Well, great. And Willy, thanks again for having me. It's a pleasure. Maybe it's because I like to do jigsaw puzzles, both of the traditional put your hands on the pieces and even the app versions of it that I use that analogy. But it's often when I talk about the difference between investing and gambling—long-term time horizon, short-term time horizon—what should an investor do? And the most important piece of a jigsaw puzzle is actually none of the pieces, but it's the picture on the box.
Because if you were to try to do a complicated 1,500-piece jigsaw puzzle without following the picture on the box, it would be a really, really difficult task. And that picture just represents actually having a plan, having a long-term plan, having that be driven by your own set of circumstances, your financial risk tolerance, your time horizon, your need for income, your shorter long-term needs for your capital. I mean, the list goes on and on.
And I think too often in this business, there is much that is cookie-cutter when providing advice. And it should never be that way because everybody's circumstances are different. And I think maybe the most important component of that picture on the box is, I mentioned, financial risk tolerance. That's what's on paper. How much can we afford to lose? What's our time horizon? But then there's emotional risk tolerance. And what is ideal is if we don't learn the hard way, if there is a really yawning gap between your financial risk tolerance and your emotional risk tolerance, because that's when mistakes are often made.
To the second part of your question, as it relates to sort of structural changes, I actually just—you mentioned kindly my X feed, my Twitter feed. I still call it Twitter. I just posted something today. It had a chart, but it also was a link to a report that I wrote last month about exiting the great moderation era, which was the era that went from the mid to late 90s up until about the 2022 inflation spike period. And that was an era marked by disinflationary trends, very little inflation volatility, very little economic volatility, longer cycles, generally a downtrend in interest rates. And in that backdrop, the most important facet of that for investors was that bond yields and stock prices were positively correlated because bond yields were keying off of economic growth, not so much off of inflation. Higher yields, meaning higher growth, great for the stock market; vice versa.
Well, you go backward, and you look at the 30 years between the mid-60s and the mid-1990s, which I nicknamed the temperamental era: much more inflation volatility, not high inflation the entire time, but more inflation volatility, therefore more monetary policy uncertainty, more economic volatility. And over that entire 30-year period, with very few exceptions, bond yields and stock prices went in the opposite direction because bond yields were keying off of inflation. Higher yields typically meant higher inflation, not necessarily with attendant better growth, negative for equities.
Now, of course, the finale of this comment is when bond yields and stock prices are inversely correlated, bond prices and stock prices are positively correlated. In the temperamental era, like the era now I think we're in, that traditional diversification of just being able to have a simple stocks bonds portfolio is limited by virtue of that changed relationship between bond yields and stock prices.
Long, long, double answer there, but you gave me a big wide question. So I went with it.
Willy Walker:
It's super helpful. Those two cycles that you talked about were 30 years. You think we're back in a temperamental era for another 30 years?
Liz Ann Sonders:
No, I doubt it will be 30 years. I think cycles have the potential to be a bit shorter by virtue of just technology and information and the structure of markets. But I don't think there's much likelihood that we go back into an environment that looks like the Great Moderation Era. Another big force behind the Great Moderation Era was massive globalization. China joined the WTO in 2001 and basically flooded the world with cheap and abundant access to goods and to labor. We had the energy boom, which allowed for cheap and abundant access to energy.
Obviously, most of those forces, those ships have sailed. And I do believe we're likely to experience shorter cycles, both cyclical cycles and secular cycles. But I think this environment for now is here to stay.
Willy Walker:
In those two cycles, thinking back quickly, I could go back and actually count them, but you've had basically Republicans and Democrats in the White House throughout those 30-year periods. And so you haven't sort of said it was a Democratic era or Republican era.
Do you think that the political volatility that exists in our country today of kind of whiplashing between one extreme to the other extreme, could make those cycles more pronounced as well as tighter? Or do you think that the political noise is sort of overshadowed by just the core economics below it?
Liz Ann Sonders:
I think where you're likely to continue to see politics come into play in terms of volatility of data and extremes in the data is more on the soft data side of the spectrum, not the hard data side of the spectrum. Things like consumer sentiment, consumer confidence, anything that is survey-based these days gets much more biased by what's going on from a political standpoint.
In fact, University of Michigan's consumer sentiment, the nature of how they categorize the respondents and the types of questions they ask, and it helps to explain why consumer sentiment in this most recent cycle hit a record low in the many decades they've been doing that survey, is a lot of that extreme pessimism was somewhat on political party lines, but also the questions that are asked by you, Mish, in that survey tend to be geared a little bit more to the inflation environment.
And inflation—somebody like me lives in the weeds of all the various inflation metrics and core versus headline and core services x housing and month over month versus year over year and the Fed's target. But the reality is that the consumer lives inflation on a day-to-day basis, and they think of inflation not month over month or year over year, but stuff is more expensive now than it was before, that sort of level step. There are so many forces that I think are driving that soft economic data to a much more significant degree than the movements we're seeing in the hard data. And it's similar to the sort of K-shaped descriptor of the environment we're in. You see a big divide between what the survey-based data is saying and what the actual hard economic data is saying. We may see some convergence there, but I don't think we're going to close the gap.
Willy Walker:
But to that, and to your point, as it relates to consumer sentiment being the lowest it's ever been since the University of Michigan started doing that sentiment survey back in the 1950s, I guess, which is right? The pessimism of the consumer or the optimism of the stock market?
Liz Ann Sonders:
I think they're keying off different things. I think the pessimism of the consumer is kind of corner store kind of stuff. It's gasoline prices, it's food prices, it's the way the consumer thinks about inflation.
I remember when tariffs were first announced, the most recent spate of tariffs a year-plus ago with Liberation Day. And the pro-tariff contingent would say, this isn't inflationary. It'll cause a one-time level step up in prices, not ongoing rate-of-change kind of inflation. And I always, when I would hear that, I'd think, yeah, but that's not how the average consumer thinks about inflation. They do think whether it's the cost of whatever it is, gasoline or eggs or beef is more expensive than it is now, than it was, fill in the blank, three years ago, a year ago, pre-pandemic. I think that consternation on the part of the consumer is likely to be there. And that just happens to be one of the overwhelming forces driving sentiment right now.
I would add geopolitics into the mix and just how partisan everything is, just that angst people feel on a day-to-day basis. Clearly, what the stock market is keying off of more than those things, the mother's milk of stock prices being corporate earnings, outside of the sort of move out of a recession where you get the base effects in earnings, where you come off that depressed base in earnings. The growth rates go stratospheric because of that low base. We've never seen anything like we're seeing right now with this parabolic ascent in earnings in an otherwise fairly healthy economic backdrop. Coming up off of pretty strong earnings, we've gone parabolic from there.
I think that helps to explain why there is this difference between sort of the angst being felt by much of Main Street and the stock market. Now there is a component of Main Street where I think the wealth effect is alive and well and what has been so supportive of our economy, where consumption patterns have been most consistently strong, is up the income spectrum. That cohort, of course, is much more likely to own stocks and benefit from that asset appreciation. That's another factor at play.
Willy Walker:
There's a whole lot in there that I wanna dive into. And one of the things I wanna dive into is the earnings growth of the Mag 7 and how that is driving the markets. But I don't wanna dive into that quite yet because that seems to be all anyone wants to talk about these days. And if you watch yourself or watch Bloomberg or CNBC these days, it seems like there's no reason to talk about anything else because of how significant they are to the overall markets and the market's health. Before we go there, which we're going to, I wanna stay on inflation. I wanna stay on rates for a moment.
As you think about the inflationary pressures and you just posted your X feed last week, I think some numbers as it relates to inflation running pretty hot on a month-to-month basis and on a year-to-year basis. How concerning is that to you as it relates to Fed funds? And is there anything in those numbers right now that you think the market is missing that could either cause Warsh and the markets to tighten further or the inverse of that, which, first of all, I have great incentives for them to do that because I'd love to see lower rates. But I've also thought that Warsh might actually change the data set, if you will. And for instance, housing is such a big component of the CPI print. And yet the numbers there and owner-equivalent rent, as you well know, no one's ever paid owner-equivalent rent. And we'll talk about housing in a second.
But do you think there's a chance that Warsh kind of changes the landscape to give him a little bit more flexibility to potentially not tighten when the data would be telling him that it's time to tighten?
Liz Ann Sonders:
I think it's too soon to tell. I mean, he's talked about trimmed mean versions of inflation rates that not only just take out what a traditional core measure would take out, which is food and energy, but other maybe extreme outliers that crop up because of whatever reason there might be. No matter what, though, no matter how you slice and dice the variety of inflation metrics out there, it's hard to find any right now that point to a Fed that should be easing monetary policy.
I was never a big believer that Warsh would come in, dovish clothing, ablazing and really try to push for lower rates. One can talk about what he said or didn't say or felt he had to say, the sock puppet concerns that people had. I've actually known Kevin Warsh for about 23 years. He's always been a bit more on the hawkish end of the spectrum. He is known as somebody that believes in the fight over inflation. I think the real calculus right now, and maybe this is not a brilliant statement here. There's no expectation built into the market right now for easier monetary policy. If anything, I wouldn't predict that I think the Fed is going to hike rates in September. I won't go as far as saying that.
That's not my job is to try to forecast what the Fed is going to do. It wouldn't surprise me; it wouldn't shock me if they did nudge rates higher. If not, I think they stay in pause mode. But I think the commentary surrounding that continues to be somewhat hawkish.
What I think is probably the most important shift that started to occur under Powell, not just since Kevin Warsh became chair of the Fed, is there's more dissent. Even though he is not quite as big a fan of everybody out there, the cacophony of voices, I often joke about the Federal Open Mouth Committee, and I don't say that in a derogatory way because I'm not a Fed basher by any means. But lots of voices, and that's resulted in an environment where there is a lot of uncertainty. There's been more dissent, more frequency of dissents. And prior to Stephen Miran moving off the Fed, there were dissents in both directions. I think that is going to be the name of the game, with arguably fewer voices, less communication coming from the Fed, and the possibility that he might not have press conferences after every Fed meeting. Him not publishing a dot on the dots plot, potentially eliminating that altogether. There are a lot of changes afoot. And I think there's therefore going to be more uncertainty with regard to Fed policy in advance of every single meeting, at least in the near term.
Willy Walker:
A lot of our listeners on the Walker Webcast are in the commercial real estate industry. As you have that as the backdrop, as it relates to, if you will, less transparency potentially on where the Fed funds rate is going, and therefore less transparency on where interest rates are going. What should commercial real estate investors, owners be keeping in the back of their mind as they underwrite deals going forward, as it relates to both the price that they're paying, and then also their cost of financing?
Liz Ann Sonders:
All right, well, let me say, I'm going to answer really broadly, because an essential caveat is, this is not my area of expertise whatsoever. I can talk about the relationship between the long end and the short end and volatility therein, but in terms of advice to commercial real estate operators, barking up the wrong tree with me. It's just not my area of expertise.
I think that very clearly the environment we're sitting in right now, and some of the recent weakness in the equity market is a function of some breakouts on the upside in yields. And we're seeing it well out the maturity spectrum with the highest level for the 30-year yield since 2007. And I think there's psychological points too, especially for a yield like the 10-year, which has the highest correlation to equity market performance. And it's not so much levels that matter, but it is speed of the move and also shape of the yield curve.
I think the speed of the move, the fact that from a level standpoint, we're back over 470, I think has caused some angst. For now though, the shape of the yield curve is not to the disadvantage of the economy or the disadvantage of the equity market. When you start to really see problems erupt, it's usually a function of both the combination of what we're seeing out the maturity spectrum, but also what the yield curve looks like. That relationship between the short end and the long end.
We do rate all 11 S&P sectors with degrees of favorability. And on the least favorable end of the spectrum right now, and this is not permanent, is the real estate sector within the S&P 500, for what it's worth.
Willy Walker:
And you also have a graph up there as it relates to 52-week highs. And I think it's a two-week or two-month high chart that you have. And I looked across it last night, and of all these ones that are hitting 52-week highs, the real estate sector is the one that has only, I think 3% who hit a 52-week high in the last two weeks or something.
Liz Ann Sonders:
And recently it was 0% both at four-week highs and 52-week highs for that sector. It has certainly not been a big breath participant in what until very recently was the move to all-time highs for the S&P.
Willy Walker:
Yeah. Are you concerned about the nation's debt? You've posted out quite a bit on this, and there was a Schwab research report that was talking about a couple of things.
One, the budget deficit and the fact that the deficit now has really become structural. And it used to be that in good times we borrowed less, and that in bad times we had to go and back up the truck and do a lot of borrowing, as we did during the pandemic, as we did during the GFC. Now it appears to be even in good times like we're experiencing today, deficits are being printed at sort of breathtaking rates.
And then in the Schwab piece, your colleagues talk about the Cassandra song from Greek mythology that nobody actually listened to until it was sort of too late. They're very clear in that research note saying that they don't feel like it's an issue today, and yet at the same time really kind of propping it up there.
As I read that, Liz Ann, and think about what we do, which is sell debt on a daily basis, I sit there and say, well, I read that. I'm not terribly concerned about the US defaulting on its debt tomorrow. Yet at the same time, long-term lookout, if we keep printing these deficits and increasing the federal debt well over 100% of GDP, that's just gonna put increased pressure to the upside and not to the downside. You agree, disagree, anything that I'm missing in both the report and what you've printed out?
Liz Ann Sonders:
100% agree. I think, first of all, there's a lot of misunderstanding about the deficit and the debt. Probably the number one question I get at client events for years now is something deficit and debt-related. And there's often a follow-on. Sometimes the question is very vague. What are your thoughts on the deficit and debt? Then it might be a little bit more specific. Are we going to hit some tipping point? Sometimes a client will provide even more specificity and say, are we going to default on our debt? Are we going to lose? Is the dollar going to lose reserve currency status? Is Japan or China going to figuratively wake up one day and just start to dump US Treasuries? Sometimes there's specificity around the question. And I'll get to sort of those three specific things in a second.
But what is amazing to me is how little understanding there is, even Willy, the difference between the terms deficit and debt. And I'm an equal opportunity critic here. I have heard politicians on both sides of the aisle conflate the two. And one might talk about the deficit being more than a 100% of GDP. And it's like, no, that's the debt and vice versa.
And your audience is a sophisticated audience, but I can't tell you how many times I've decided to start this conversation by just saying the deficit is the annual mismatch of what's coming in and going out. Debt is a cumulative effect of running deficits. And I've had people who, God bless them, come up and say, I had no idea that was the difference. There's that base understanding.
I think the investor class cares deeply about this subject. I think the average constituent cares about it in the abstract, but they don't quite know how to quantify it. They don't know what it really means to them. But what they do know, if asked the question, is they're highly unlikely to vote for much higher taxes or much lower spending on the services that they rely on.
And as a result, if there's one thing that there's a lot of bipartisan support for in Washington, is kicking this can down the road. And the real bottom line is we don't start to solve this problem without touching entitlements. Mathematically, you can't do it. DOGE wasn't the answer to that. That was a drop in the bucket, even if it went to the extreme that it was billed to be. You could raise taxes to 100% on everyone, everything, every business, and you could cut spending to 0, and you still wouldn't solve this problem without something being done to entitlements. It's just not very popular.
The real kind of solution, mathematically, to this problem is just to have the growth rate in debt be lower than the growth rate in the economy. Because then, mathematically, you start chipping away at the problem. There's just not much incentive to do it. We're not going to default on our debt. We can pay our bills. The dollar is not going to lose its reserve currency status. There's no replacement for it. It's not the euro. 17 individual bond markets, certainly not the Chinese yuan, not really convertible. It doesn't represent a high share of global trade. I used to get, well, will the rating agencies downgrade US debt?
That ship sailed.
Willy Walker:
You've already done that.
Liz Ann Sonders:
All three of them have done that. The first one back in 2011. The real implication of this is the crowding out effect. The downward pressure it puts on growth because of less productive sources. I think now we're really coming to grips with the upward potential pressure on interest rates. You've seen Japan now bringing down their treasury holdings. Looks like they're about to catch up to China, which has been diversifying away from such a heavy holding in US treasuries for about a dozen years. That's not a new story. And it's not a brand new story for Japan either. But the pace of retreat has picked up a little bit. And now there's a lot more competition for treasuries, especially with the AI boom moving into the debt markets. I think all else equal, unless we have a serious dislocation in the economy or some miraculous retreat in inflation, more likely than not, we're in a higher-for-longer kind of backdrop.
Willy Walker:
One of the data points that that research piece by Schwab pointed out that I thought was very interesting was that Japan's debt-to-GDP ratio is 200% of GDP in outstanding debt. And the point there is A) we're at 100. Hopefully we don't get to 200 anytime soon, but that you've got a real runway there, except for the fact that in July, when Japan needed to raise additional debt, which they're always out in the debt markets, they were paying a premium to do so.
And so that's back to my underlying question to you as it relates to just the trajectory of rates. Should the assumption be that all things equal, they're probably continuing on an upward tick rather than a downward tick?
Liz Ann Sonders:
I think all else is equal, yes. Again, barring some sort of serious economic dislocation that kind of resets things from a rate standpoint, I think the path of least resistance is higher. It's the pace of that move higher that really will, I think, ultimately define whether and how both the equity market as well as the economy can navigate through that higher-for-longer backdrop.
Willy Walker:
You posted a graph talking about consumer debt on your X feed that has 18 trillion of consumer debt outstanding. 70% of that number is mortgages, which I think one of the big important pieces to that is how much of that is locked in on a mortgage that was done in 2020 or 2021, which actually has the consumer income-to-debt ratio 9 points below, 9 percentage points below where it was pre-pandemic. That lock-in effect on the mortgages has been very, if you will, beneficial to consumer spending. It's been very beneficial to travel and the leisure markets.
Liz Ann Sonders:
But it hasn't been beneficial to the supply of existing homes because people have been locked in.
Willy Walker:
There you go. And I wanna get to housing after this, on the retail spending on the consumer, and then the next, I wanna go to housing, and then we'll get down to the Mag 7. But on consumer spending, I watch quite closely credit card debt outstanding and then default rates. And as you well know, while they have come up significantly since just post-pandemic, when everyone was getting a check from the federal government, they aren't, from a historical standpoint, significantly above where they are pre-pandemic. And Cap One and a bunch of the others reported earnings over the last three weeks and everyone, as it relates to delinquencies and net charge-offs, is not sitting there flashing red lights. What's your sense Liz Ann on the consumer at large and whether the consumer is, like retail sales in July, I saw you posted on this too. They were slightly down month-on-month but nothing to sort of say the consumer is sort of given up. Fast forward, are you concerned about the consumer here? Or do you think the consumer continues to have legs, as they say?
Liz Ann Sonders:
Concern is a little bit more down the income spectrum. Where you are starting to see some troubling statistics around late payments and defaults, and delinquencies is fairly well down the income spectrum in that subprime area. And those are always pockets of concern anytime you get to a potential economic inflection point. I'm not terribly concerned as you move up the income spectrum. I think there's, notwithstanding the lack of mindfulness around debt at the public sector, the government sector, consumers have become more mindful about debt. And the lesson wasn't really pandemic-related. It was a global financial crisis-related and the bursting of the housing bubble. Then we had the post-pandemic environment where stimulus was so massive. It boosts not only the traditional savings rate but what was called the excess savings rate. So much of that consumption came out of that excess savings bucket. And then once that was largely drained, traditional savings.
Now the savings rate is pretty low right now, about 2.5% right now. That could even drain a little bit more. I think the hit to consumer spending is not so far anyway, going to come from concerns about debt. I don't think it comes from concerns about the savings rate coming down. It's general confidence in the labor market. If that were to crack, I think that's a big problem, but maybe most importantly, the stock market. An important history lesson from the period of the late 1990s into the dot-com bust in early 2000, more so maybe than what everybody's talking about, is the AI bubble akin to the dot-com bubble. Are we seeing shades of the same thing? Circular financing versus vendor financing. But I think an important lesson was what happened in the aftermath of the bursting of that bubble.
In 2001, the US went into an economic recession. It wasn't a terribly severe recession. It wasn't a terribly long recession. I think it was only 10 months, but I think it wouldn't have happened at all had it not been just for the bear market and stocks. There were no major economic dislocations. There wasn't a credit crunch. There wasn't a financial system collapse. It wasn't the Fed rapidly raising interest rates. It was the wealth effect and the fact that we went into a bear market, and that pulled the economy down with it.
I do think we have a bit of a chicken-and-egg to be mindful of as it relates to the economy as a driver of the market and, in turn, the market as a driver of the economy. And that, to me, represents probably the thing you should have at the top of your list when assessing what could cause an unwinding of this bull market. What could bring on the next bear market? There could be much more weakness in the labor market and the economy, and vice versa. What could bring on the next recession could be the next severe correction or bear market and stocks. I think that interconnectivity is tighter than it's been in the past.
Willy Walker:
And the one point to keep in mind on that scenario that you just talked about in the early 2000s in the dot-com bust was 9-11. Obviously as the sort of shock that made it so that it shifted. And then us then going into war and what we got from a growth standpoint on the investments in being at war and the war on terror.
Let's talk about housing for a second. Kokko, can you put up the slide here that shows the number of buyers... This slide that I pulled from your X feed, Liz Ann, is what I thought...
Liz Ann Sonders:
I gotta put my glasses on to refresh my memory here.
Willy Walker:
No, no, it's okay. The number of buyers has fallen to a record low, and you can see the number of sellers now is not at historic highs, but way, way up there. And the number of buyers is at a historic low as it relates to the number of people who are out in the market. We can pull that down.
I look at that slide, and by the way, being in the housing market, I see a whole lot of slides, and I pulled that out last night and sent it to my chief of staff. I was like, this is an exceptional slide. But I see that, and I say, okay, that is a slide as it relates to a very challenging home-building, home-sales market. The Delta between owning a single-family home and renting today continues to widen. And as a company that finances a ton of multifamily across the country, that's net positive for the multifamily industry. And yet at the same time, Berkshire Hathaway reported last week that along with increasing their holdings of Alphabet, they also invested in two or three home builders. What does Berkshire Hathaway see, Liz Ann, that we're not seeing in that slide that shows an increasing number of people who are sellers rather than buyers?
Liz Ann Sonders:
Well, they probably see value. Berkshire Hathaway, unlike a lot of participants in markets today that have time horizons measured in nanoseconds, Berkshire Hathaway tends to take a much longer-term view. And we've had compression in the housing market for quite some time. And they're probably looking at picking off an interesting opportunity.
The low level of buyers is a function of a number of things. There are sort of three legs, as you well know, to the housing affordability stool. There's the prices of homes, there's the mortgage rate, and then there's the income that we're taking in. We don't have, to the benefit of housing, two of those legs. Prices have stayed relatively high even as sales have come down because you've had that dearth of supply coming from the existing home market because of people that have been locked into mortgages. Mortgage rates are now on the rise again, and incomes have been relatively healthy. But there's another force at play here, and it doesn't have anything to do with the numbers, with the math, with interest rates, with average home price. And it's tied into social media. It's tied into the biases and interests on the part of the younger generation. It's tied into younger people not getting married as often as they have in the past, not having kids as much, really thriving based on experiences, less about stuff, wanting flexibility, including where they live, wanting to be unencumbered by some of the weightier things that encumber us in our lives. And it's tied into why a lot of people are looking at what is really the value of a four-year college education right now. Maybe there are other ways to get an education. I think this is a cultural thing. It's a generational thing that's happening, and it ties into why I don't think we're going to see why we're not just in some lull, and we're going to go back into what would be into the normal upside cycle for housing. I do think to use the oft-cited expression: this time is different.
Willy Walker:
And so if those cultural shifts have happened, not just the economic shifts, is that risk on as it relates to multifamily? I mean, Equity Residential and AvalonBay just merged to create the largest multifamily REIT out there. Are those consumer behaviors that you just underscore as it relates to not really wanting to own anything and not really starting household formation earlier and all that. Wouldn't that be a play for multifamily over single family? Or is there something missing in that?
Liz Ann Sonders:
No, but I think that you can get overbuilding on the multifamily side too. You've obviously had—
Willy Walker:
Which we've been chewing through for the last three years.
Liz Ann Sonders:
You've had underbuilding on the single home. You have the supply-demand balance that comes into play in multifamily too. But yes, in the aggregate from a demographic standpoint, I think the sort of the forces with multifamily more so than single family. But that doesn't mean you're not without risk in the overbuilt part of the cycle, which to your point has been going on for a few years now.
Willy Walker:
One of the interesting things is that everybody in the commercial real estate space and multifamily space was saying survive to ‘25 when we got into the tightening cycle, and we had all this excess supply. And then we got to ‘25, and there was no ability to push rents because there was still too much inventory out there. And then everyone kind of moved into 26 and was sort of like, okay, maybe we can see some rent growth coming into the market in sort of the end of ‘26 and beginning of ‘27.
And one of the big questions there was why hasn't household formation, why haven't the people been lining up to go and fill up the multifamily properties? If single-family is at such depressed levels, which that chart that we just showed demonstrates. And one of the things that kind of is the answer that a lot of people come to is that immigration policy and the closing of the border, and to a less degree deportations, but just the closing of the border has made it so that household formation stepped down, and therefore there weren't that incoming renter to pick up the supply.
But then if you follow that along Liz Ann, why haven't we seen wage inflation? Because if the people aren't coming in and we're not getting the people renting, you would think that the job market would be much, much better. And that the person who previously was upset about the immigrant coming in and taking their HVAC maintenance job in Texas, to use an example, that person's no longer there. Why haven't we seen wage inflation play into the inflationary print in a more significant way? If that lack of a consumer on the multifamily side actually was due to a lack of illegal or legal immigration?
Liz Ann Sonders:
Well, I think it's gonna take time for the constraints from an immigration standpoint to fully work its way into all of the data. We've already seen it in terms of a lot of the labor market statistics. The fact that the breakeven rate of job growth is somewhere around 30,000. I've seen numbers as low as 0, meaning you only need to create, call it, somewhere between 0 and 30,000 jobs per month in order to keep the unemployment rate from rising. There's very much an immigration impact there. I think it takes a little bit longer to feed into supply and demand fundamentals as it relates to housing and the supply.
A lot of it has to do with, at times in the multifamily world, the mismatch from a geographical location standpoint. I think there are operators that have sort of nailed it, whether it was luck or particular expertise and being at the right place at the right time, being in the right sort of demographic profile, understanding whether it's needs for seniors, whether it's need for students. I think it's gonna take a little bit longer to play out, but you're right. We are not seeing the kind of wage-price spiral that you might expect given general inflation pressures. And I think that is because corporate profits have been so strong in part because corporate leadership has been pretty good at reining in the expense side. And for whatever reason, you go in these long cycles of labor having power over capital. Capital is measured by corporate profits.
We actually, in the early years coming out of the pandemic, labor really picked up power in the economy, and started to see an increase in the share of the economy represented by labor and by wages. And you were seeing corporate profits move down. That has already reversed back in the other direction and labor just doesn't have as much power. And we're starting to see capital wield that power again. And companies have been successful in keeping a constraint on wages such that the latest wage data is running at a pace below inflation.
So we're not seeing that wage price spiral. That's a potential risk which could exacerbate the inflation problem. That might be great news for the worker, but not great news in terms of the inflation backdrop and obviously the Fed reaction function.
Willy Walker:
And so we've talked about labor, we've talked about housing, we've talked about inflation, we've talked about rates. AI, which is driving this market, and we've taken three quarters of the discussion on non-AI stuff. I'm sure that this is a little bit atypical discussion for you because everyone wants to be right with it.
You've talked about the three Cs related to AI: the creation phase, the catalyzing phase, and then the cascading phase. Can you describe for our listeners those three phases? Where are we today? And where do you see disruption coming in the cascade phase?
Liz Ann Sonders:
The create phase is just that, the creation of what we know of as AI. And going back to 2022 and ChatGPT and the other large language models, the hyperscalers, that was the creation of what we think of as AI. Then the catalyzed phase, which arguably we're still in, is the build-out of AI, the infrastructure associated with it, the data centers, figuring out the energy needs, the power needs, the import-export relationship of how we do this. The fact that we shifted from a cash flow finance model to now more of a debt-financed model. And then the cascade phase is how AI is cascading into the economy. And it's a phase of both disruption and opportunity.
Everybody's trying to figure out the winners and the losers. How much longer can this go on? When the catch-up might be to what to some degree is sort of a paper boost to earnings, and when depreciation catches up to that. But in the meantime, the growth rates are absolutely astronomical. We're looking at probably a trillion dollars of spend on an annualized basis, but that's growing fairly exponentially. And now we're in the cascade phase.
And the real goal, I think, on the part of investors is figuring out not just who the winners and the losers are, and it's already happening, how do we shift our attention away from the Mag 7 or what I've been calling the NeuralNine by just adding Micron and Broadcom into the mix because they were sort of left out oddly and then became like the two of the power players. And how much of that is now providing opportunity in the energy space, in the industrial space, in the material space, the implications that it's having for economic growth, not in a traditional sense. We know that business capital spending has become a big driver of the overall economy, with AI being a big factor in that.
But what a lot of people don't realize, and this was a lot of sort of confusion expressed when we got the weaker than expected second quarter GDP report with all this business CapEx, why was GDP growth fairly anemic? And it's because so much of that CapEx is purchases of imports more so than exports. And we don't have the offset of stronger exports. And we have rising prices of many of the things we have to import for the AI build. Well, the nature of the US economy and the way GDP is calculated, we import in general more than we export. If we're spending more on imports and we don't have the offset on exports, it accrues to the downside in terms of the math of GDP growth, even though that engine of AI CapEx is absolutely monstrous.
But I think there's just a lot of money right now that is looking for other shiny new objects, whether it's down the size spectrum into the small cap area, into more of those traditional cyclicals as a way to kind of play or ride the AI train without still just hitching the wagon solely to that Mag 7 or NeuralNine cohort.
Willy Walker:
You mentioned, not in our discussion, but in one that I listened to previously about that at the beginning of the year, there'd been a broadening of stocks that were beating the S&P on an individual basis of 60% of the individual stocks were actually beating the index. And then that collapsed back down to 15% of the stocks actually beating the index. Does that concentration of growth concern you?
Liz Ann Sonders:
Well, so the 65% where it was at the beginning of the year was actually on a trailing one-month basis. I put a table on my Twitter feed every single morning, and it looks over rolling. I don't know if I'm gonna get all the periods right, but like, rolling past one month, two months, three months, it might be six months. It goes out to rolling past year and looks at what percentage of the index has outperformed the index itself over that trailing, whatever, one month, three months, six months, one year period.
At the beginning of the year, that trailing one month period had gotten to about 2/3 of the S&P's constituents outperforming the index. At that same time over the prior year, it was only about 10%. That was a really, really big divide. Now, by virtue of the calendar and the way it works, since we have had better breadth, that one-year lookback is looking a little bit better. About 15% of stocks have outperformed the index. That 65% has come down to about 40 some odd percent. We've seen a little, it's not so much breadth deterioration in the last several weeks, but a bit of concentrated performance again. But I think it's just that it's about what is really defined this year so far is rapid-fire rotations at the industry level, at the sector level, even at the sub-industry level. And that's one of the reasons why another set of data points that I post every day on my Twitter feed is drawdowns at the index level versus drawdowns at the individual member level. The S&P so far this year at the index level only had a 9% drawdown. That was the maximum pain from peak to trough.
If you take all 500, it's actually 504 constituents because there are a couple stocks that have dual shares, but let's just call it 500. If you take all 500 stocks and look at their individual maximum drawdown at some point this year, and then average them together, it's negative 24%. The average stock has had a bear-market-level drawdown this year. It just didn't happen all at once. It happened via the process of rotation. It's more extreme for the NASDAQ.
The NASDAQ at the index level had a 13% maximum drawdown earlier in the year. But again, if you go member by member and you take the average maximum drawdown, it's -44%. Now, that's not a bad way to correct excesses, whether it's valuation excesses, sentiment excesses, whatever it is, by having it occur via process of rotation. That's actually a relatively normal environment. Those numbers I cited you sound wow, but you can look at every year what the maximum drawdown index was for individual members. And there's usually a pretty wide spread. But we just got to such an extreme where it was only a small handful of stocks that were performing well and nothing else was, that this is more a normal environment. And that's not a bad way to correct excesses happening through churn and through rotation. It's just a different environment for investors than one where it was sort of a unilateral decision: just buy tech or buy the Mag 7 or buy the top 10 stocks, set it and forget it.
And you did well. I think that environment has changed. There's more concentration still in terms of earnings growth, a little bit less concentration in terms of the drivers of performance.
I mean, you've got that NeuralNine right now. I think Micron is the, now it might be Nvidia. It's either Micron or Nvidia. They're like the number two or number three highest contributors to S&P returns. But Tesla at the other end of the spectrum is the 500th ranked contributor to S&P returns. This is not a cluster anymore. And this is a lesson this year of teaching investors not to think monolithically, not to think and invest in clusters because that's just not the market environment that we're in right now. And I don't think we go back to that level of concentration. I think this rotational kind of market is likely to stick with us for a while.
Willy Walker:
When you talk about those specific stocks, I heard you say a quote from you is better or worse off matters more than good or bad. Will you explain that?
Liz Ann Sonders:
That is one of the most misunderstood concepts, especially for people trying to connect the dots between what's going on in the economy and what's going on in the market. It's human nature for us to see a report on retail sales or a report on industrial production or payrolls, whatever it is, it doesn't matter. And think, was it good or was it bad? Was it strong or was it weak? But it's the rate of change, it's inflection points, it's the direction that tends to matter.
I remember seeing earlier in the year, the stat that showed the aggregate growth rate of the MAG 7 expected to go from what had been 60%, 70% earnings growth and start to move down and that you were going to see the other 493 start to move up. And I heard people say, but if the MAG 7 growth rate goes from 65% to 40%, 40% is still an incredibly strong growth rate, but it's the direction that matters. The market is a forward-looking indicator. Its role almost is to sniff out inflection points and to try to figure out when things stop getting better and start getting worse or vice versa.
It's why the market typically peaks in advance of recessions. It starts to see that things have stopped getting better, stopped getting worse. When you look at the start of recessions historically, at that moment in time, you take a snapshot, particularly pre-revised data on things like payrolls, and you look at what the economic data readings were in an absolute sense, in a level sense, they all look pretty darn good.
The reason why the recession began is because they stopped getting better and they started getting worse. Recessions are dated as having started at the peak in the data, not when the data is already compressed significantly. Conversely, recession finales are dated officially at the point where the data stops getting worse and starts getting better. But by definition, stops getting worse, starts getting better, you're at the bottom of the V. Snapshot in time, the data looks absolutely horrific, especially lagging-type data like the unemployment rate. The unemployment rate is always low when a recession has started and is always high when a recession has ended. And that's the complete opposite of the way human nature, we approach things. But it's understanding that better or worse typically matters more than good or bad. And the same thing you could apply to earnings growth rates, better or worse can matter more than good or bad.
Willy Walker:
We've talked a lot about data. I wanna finish on how you advise the individual investor. And you started off talking about the fact of, trying to separate the signal from the noise, if you will, and making sure that you're not making reactions to, okay, some stock has fallen precipitously, sell it now, because it's actually, to your point, there's the leading indicator of where it actually might go in the future.
But you posted on your X feed a chart that I wanna pull up here, which is about sports betting, competing with Gen Z investment dollars. And you wrote, this is a shocker. And I just had to pull it up because to those who were listening and not being able to see this, it's a chart that breaks down by the various demographics, Gen Z, millennials, Gen X, boomers. What percentage of them actually have participated in direct sports betting, okay? And then the other side to it is what percentage of that cohort has treated sports betting as a deliberate part of their long-term financial strategy.
And on this chart, it shows that of Gen Z, there's a huge percentage of them that have actually participated in sports betting, but most shockingly, 26% of Gen Zers who were polled in this source, which it's called Betterment, did the poll, 26% say that sports betting is a deliberate part of their long-term financial strategy. Let's pull that back down.
Liz Ann, you started all this about talking about the stock markets as not being a casino and that people should be deliberate about where they're investing. And yet here we have a generation in this poll by Betterment that says that they're using sports betting as part of their long-term financial strategy.
Liz Ann Sonders:
There has been such a blurring of the lines between gambling and investing, particularly through the marketing associated with many of the sports betting platforms and prediction markets. And that's sending a message that results in a response like that, where 26% of that generation says, it's part of my investing strategy. At Schwab, we have been on a mission in making sure that we are the voice trying to differentiate gambling versus investing.
Shameless plug, I wrote a piece back in April that's still on schwab.com. All of our research is in the public domain. You don't have to be a client. And it's just, it was titled Gambler's Blues. And it was a deep dive into this blurring of the lines between gambling and investing. I actually got a text the day or two after it was published from Chuck Schwab himself who said, I loved that piece.
We're gonna run with that. And my voice and some of the words in that report are now in one of our commercials.
I've never been in a Schwab commercial. The end of it has a video of me just doing my monthly video on the subject. We really wanna be a voice. And the way to frame it that I came up with when writing this piece was: investing is about owning. Gambling is about hoping. When you're an investor, you are a participant in the ownership of capitalism and the future cash flows of whatever the investment is. And most importantly, perhaps over any reasonably long time period, the odds are with you.
When you're gambling, you're just hoping. And you're not a participant; you're a spectator. You're placing a bet; you're stepping back. You obviously hope it's going to be a windfall. More likely than not, it's going to be a full loss. And the blurring of the lines is really dangerous. I actually think it is a potential sort of financial literacy crisis in the making. We certainly wanna do our part in trying to unblur the lines of those two. But owning versus hoping is probably the best way to think about that.
Willy Walker:
Liz Ann, you have unblurred a lot of issues in the last hour as it relates to your perspective on the market and where we are. I'm super appreciative of you spending the time. And I appreciate everyone who tuned in this week to listen to Liz Ann Sonders from Charles Schwab.
Thank you, Liz Ann. And thank you everyone for listening this week.
Liz Ann Sonders:
Thank you, Willy.
