MMN Editor

Transcript:

Caroline Woods: Joining us now is Kevin Gordon, head of macro research at Charles Schwab. Kevin, welcome back to the desk. Great to have you.

Kevin Gordon: Good to be back.

Caroline Woods: All right, so let’s talk markets. We have Apple falling after earnings last night. We have semiconductors rallying. We have the Nasdaq still technically in correction territory down about 10% from the highs. After everything we’ve heard from all of these tech giants. Are you more encouraged or more concerned about the AI trade.

Kevin Gordon: Well, I think that from a from a broader market perspective, I’m more encouraged because you’re going through what is a pretty you know, what it’s become now a normal almost correction for the tech sector, especially in the case of the Nasdaq-100. So the third correction this year, or decline of at least 10% this year. And despite that, the rest of the market has continued to rebound.

Kevin Gordon: There’s a little bit of a defensive tilt to it. So it’s not necessarily the best kind of flavor of a rebound. But financials have been doing well. Small caps have been bouncing a bit. And then most importantly the equal-weighted S&P has definitely recovered and is almost back to its all-time high. But I think for tech in particular this sort of happens every earnings season.

Kevin Gordon: There’s kind of this scrutiny from the investors, the investor cohort around what does the CapEx plan look like, and can you really hit all of the metrics in terms of a beat on earnings? A beat on revenue? Is the CapEx number right, which is different for every company, seemingly especially for the hyperscalers. But you kind of go through this every earnings season seemingly, and it’s getting a little bit more, I would say, aggressive with some of these drawdowns, especially within communication services.

Kevin Gordon: That’s been a notable laggard. But I think particularly in that space, one of the reasons that we have become a little bit less favorable on the sector was from a valuation standpoint. So I would argue a lot of that is maybe just a washout in some of the excess that you would see from multiples.

Caroline Woods: So you would look at this as sort of just a healthy reset before money goes back into Big Tech. Or do you look at the rotation that we’ve been seeing as something that could be?

Kevin Gordon: I think it’s a well, I think it’s a it’s a sort of a needed reset for tech because so much of the excess in the earnings estimates and the expectations are actually just concentrated in information technology, the sector, if you want to think about just the way it’s labeled, the GICS sector, information technology, when you look at forward earnings estimates in that sector, they’re up by more than 90% year over year, which is the rate of change we have never seen ever in history.

Kevin Gordon: Unfortunately, that’s really not spreading to the rest of the market. I mean, even if you look at communication services those earnings expectations are not as aggressive. So I think the fact that it’s happening this most of this corrective activity is is almost exclusively in tech right now. And that’s where most of the pain is. And to my earlier point that the broader market recovering that to me I think is sort of this healthy reset, whether it goes back exclusively into tech at the expense of the rest of the market.

Kevin Gordon: I’m not so sure if that necessarily holds up, because you still have the economy that’s growing, still a labor market that is expanding, albeit in a choppy, sort of uneven way. But I think in that environment, the cyclicals can continue to do well, which is why we have one of the reasons we have a more favorable rating on those sectors.

Caroline Woods: Okay. Well we’ll broaden it out and talk about kind of your overall portfolio positioning in just a second. But first, do you look at any down days and some of the pain that we’ve been seeing in tech as a buying opportunity?

Kevin Gordon: I think it can be, but particularly up the quality spectrum. I mean, this actually exists and sort of, I think rings true for large caps and small caps. One of the more definitive features of the market this year, I think, particularly because of what’s happened with rates. And now that there’s a little bit more of this constraint from, from a cost of financing perspective, has been in that higher-quality space, we’ve just seen a lot of damage done to lower-quality, unprofitable companies.

Kevin Gordon: And, you know, I always sort of get a response to that where it’s sort of the ultimate, statement. But we have gone through cycles, especially post-pandemic market cycles, many market cycles where there are times when the unprofitable cohorts are running and outperforming the market dramatically. We are not seeing that this year. And I think that the rate structure is sort of central to that.

Kevin Gordon: Oil is playing a little bit of a, of a role. But I think because of how much rates have moved up, particularly at the long end, that has really driven this divergence between that higher-quality and lower-quality, performance, particularly within tech.

Caroline Woods: So if someone says, how do I know if it’s up the quality spectrum outside of just being profitable? Yeah. What should they be looking for?

Kevin Gordon: I mean, there’s a number of metrics. I mean, interest coverage is one of my favorites. So if you have a strong interest coverage ratio that sort of tends to be kind of I think the catchall for, for quality. And in my view,

Caroline Woods: What does interest coverage mean?

Kevin Gordon: Being able to service your debt costs in terms of your interest expense, and having that from what you already have in cash flow terms. You don’t necessarily want to have that ratio slip below one. That doesn’t necessarily screen well, I would say, for up in quality. But there are other metrics around strong revenue growth.

Kevin Gordon: Strong earnings growth if you have, you know, positive free cash flow. I would say that probably rings more true for companies that are smaller, because we’ve seen a lot of the hyperscalers slip on that metric in particular. But they have other businesses and other parts of their businesses where revenue growth is strong. So there’s always a little bit of a caveat.

Caroline Woods: So hyperscalers are still on the high end of the quality.

Kevin Gordon: Spectrum when you can when you combine a lot of those metrics. Yes. So they sort of still fit in that category.

Caroline Woods: You know as we broaden it out though, the S&P 500 is up about 11% year-to-date. But if the S&P 500 is doing so well, why doesn’t it feel like that strong of a bull market.

Kevin Gordon: Yeah I you know I was I was actually thinking a lot about this morning and just looking at a very simple year-to-date chart of the index. And most of the gain was made in about 44 days from the low that we had, you know, in March. And then that sort of rocket move that you had into April.

Kevin Gordon: And then since then it’s been sort of a chop. It’s been a chop sideways since then. And then before that, that, that dropped that sort of waterfall decline into March, you had had the market trending just sideways for a couple of months. So I think a lot of it has to do with in the near term, it doesn’t feel like the market’s gone anywhere.

Kevin Gordon: Plus, you layer on to that. The fact that all of this corrective activity in tech, where a lot of investors sort of you feel exposure certainly, but are sort of drawn to in terms of the coverage that they get. I think a lot of that is sort of fueled the bears sentiment. But it is interesting because it’s very much at odds with what we see from, from a behavioral standpoint and how much money continues to go into the market.

Kevin Gordon: Equity ETF flows are still quite strong when we look at investor positioning and that sort of purchase activity might be slowing a bit, but overall positioning and how people are exposed to the equity market has not slipped. So I think that’s an interesting juxtaposition. And actually in a way, maybe keeps more of the of the bullish energy alive for the market because you don’t tend to get significant corrections or bear markets until both the attitude, the behavioral component are extremely bullish and in optimism and euphoric territory.

Kevin Gordon: We’ve we’re still waiting for that attitudinal component.

Caroline Woods: If it feels too good, it’s probably bad. However, I was taking a look at your notes, and you say the average stock in the S&P 500 is actually down more than 25%, and the average stock for the Nasdaq is closer to 50%. So does that mean that this is actually a bear market disguised as a bull market?

Kevin Gordon: Well, particularly, it’s the average maximum drawdown. So at any point this year, you’ve seen the average stock in the S&P, you know, an average maximum drawdown.

Caroline Woods: It’s not here today.

Kevin Gordon: It’s actually maximum. Although as of yesterday’s close the you know, percentage of stocks in the Nasdaq-100 that are in a bear market. So down by more than 20%, you know, at this moment, just breached 51%. We were a little bit higher earlier this year. So that’s not some, you know, red flag number. That means that we’re about to see the index go into a bear market.

Kevin Gordon: But you see, the point is you’ve seen just a ton of churn and a ton of rotation under the surface. And and we’ve really been trying to emphasize to investors and our clients that is becoming increasingly the norm in this post-pandemic market environment. It’s not normal to see that in history, but because of the weight that you have from the mega-caps, from the hyperscalers, the fact that the ten largest companies make up 40% of the S&P 500’s market cap that is leading to these, you know, sort of either or days.

Kevin Gordon: You know, the index could be doing one thing, but the rest of the market could be doing the opposite. And then at times you get serious corrections and serious rolling corrections very much like we’re in right now for, for technology.

Caroline Woods: But given tech’s weight in the S&P 500, if it’s not going to be tech that’s really driving this market higher, where is it going to go then?

Kevin Gordon: Well, it’s already filtered through to I mean in the rebounds. You know you’ve seen other parts of the market whether it’s consumer discretionary and staples. They’ve sort of been both rebounding together or financials which is a significant sector weight wise in the index. You’ve had these pockets of outperformance lately.

Caroline Woods: It’s just not—

Kevin Gordon: Felt at the—

Caroline Woods: The highs are surpassing that.

Kevin Gordon: And this is just the math of the index. I think the math works against you as a cap-weighted index investor, if that’s how you’re approaching this. If you’re looking at it sector by sector, you may be able to sort of play it a little bit better. But the from a cap-weighted perspective, for especially for an index like the S&P, if you don’t get that strong participation from tech, you’re not necessarily going to feel it at the headline level.

Caroline Woods: So for the retail investors who are tuning in, yes. Should they not be just investing in the S&P 500 at this point?

Kevin Gordon: I mean, I would always argue that you should expand beyond just a large-cap index. I mean, in any diversified portfolio that makes sense, but also know what you own, even if it’s at a sector level, because you can get some pretty significant concentration at the individual sector level. And it’s not just in tech or comm services.

Kevin Gordon: Communication services is the most extreme, I would say, if you’re looking at the sort of percentage that even the top two companies make up of that of that sector, it’s well above 70%. So you’re essentially looking at really just two companies, for, for communication services, alphabet. And that’s meta. But in other sectors, you wouldn’t think about it.

Kevin Gordon: Energy as an example, the two largest members in that sector make up more than 50% of that sector’s market cap. So, I think taking an equal-weighted approach from a sector perspective can make a lot of sense if you want to guard against some of that more sort of, you know, not extreme, but that more intense downward pressure that you can get whenever tech in these kind of tech adjacent parts of the market do go through it, you know, an intense selloff.

Caroline Woods: So if leadership continues broadening beyond Big Tech, which sectors are poised to benefit most from here.

Kevin Gordon: So we’ve had favorable ratings. And some of them were recently upgrading an area like energy. But if you look at our favorable ratings for the 12 sectors, it’s energy financials, industrials materials. So very cyclical nature. And then we’ve had healthcare in there for a little bit just because from kind of an AI beneficiary standpoint, we wanted to have a little bit of a barbell approach.

Kevin Gordon: Health care is always seen as this kind of classically defensive sector. But when you think about some of the some of the potential benefits from a profit margin, an efficiency perspective, kind of seems like a sector that’s sort of ripe for, for that. But it’s not something that we would say. I mean, these are not short term tactical calls.

Kevin Gordon: So it’s not as if in the next two months we think health care is going to be the top performer. We just think that there is potential for some momentum there in terms of the beneficiaries of technology.

Caroline Woods: But health care is on the opposite end of the barbell is energy. Yes, yes. Where is tech in that barbell?

Kevin Gordon: Techs in the middle. We’ve had it neutral for, for quite some time now. You know, knock on whatever has, you know, worked has worked pretty well. And I would say, you know, neutral is not a bearish call. It’s not saying that we think that the sector is going to do nothing. But when you look at relative to the market, has not dramatically outperformed the S&P 500 over the past several months, you can actually almost take it back almost six months, to this point where where tech is not done well, even on an equal-weighted basis, the tech sector so far in the second half of the year is down.

Kevin Gordon: Not dramatic, just slightly more than 4%. But we just feel that there’s other opportunities outside of that sector because it definitely had its day in the sun. Significant performer, you know, post post bear market low in 2022. But in that process, and as the bull market has continued to age, there have been other sectors that have been sort of swept up in the momentum.

Caroline Woods: What does a neutral tech exposure and an everyday retail investors portfolio look like?

Kevin Gordon: It depends on how you measure it. I mean, if you want to if you want to measure it like you would in a cap-weighted index, you’re going to have some pretty significant exposure. But again, if you want to take an equal-weighted approach, I think that really does level the playing field for some of these sectors, especially energy, which kind of get thrown to the wayside a lot because of just their shrinking footprint over time.

Kevin Gordon: I mean, the energy sector is about 3% of the S&P 500 market cap. So there are a handful of tech companies that are larger than the energy sector, when you think about it in those percentage terms. So I think just because of the bearishness in some of these deeper cyclicals and the outflows in those areas, particularly energy, the fact that you’re continuing to see the economy grow, the fact that you have this upward pressure on commodity prices probably makes sense to to have some exposure there.

Kevin Gordon: I mean, everybody’s situation is different and how they want to sort of have exposure to those areas. But we would just say don’t throw them away and sort of discount them altogether. Because the inflation backdrop we have, the growth backdrop that we have is still very much in favor of having that cyclical exposure.

Caroline Woods: And you’re still bullish. You think this is a market that can continue to move higher.

Kevin Gordon: Yeah. But not without I think a lot of this continue to chart. So I think getting used to again, back to the point of this post-pandemic market environment, the churn becoming the norm, you know, going through these periods where the S&P 500 is unchanged for several months now, yet you do have these pockets of outperformance. You just can’t see them.

Kevin Gordon: You really have to peel that. We call it peeling back the onion, the market onion, and taking back one layer and finding those outperforming pockets. It just takes a little bit more research below the level of the index. So I’m bullish on that.

Caroline Woods: Are there any areas though sector wise that you think would you’re kind of too late to get in at this point.

Kevin Gordon: I never think about it as getting in, because to me, a longer term strategy of investing in a sector is how you want to position it in a portfolio and what it can do for you. So from that standpoint.

Caroline Woods: If I don’t have energy, like specific energy exposure, healthcare exposure, if I am pretty broadly diversified in tech or the S&P 500 and I want more exposure after listening to you, are there any areas right now that have already I mean, energy is by far the best performing sector. Yeah. So far this year, is it is it too late to add here or do you have to wait?

Caroline Woods: I know you can’t time the market, but you have to wait.

Kevin Gordon: I don’t think so, especially because—and not everything boils back down to the Fed and what they do—but if you think about the profile of the economy, it’s still growing. Certain parts are stronger than others. We definitely had a weakening of the consumer going from the third quarter into the fourth quarter. So most of the strength of the impulse is still coming from business investment.

Kevin Gordon: But broadly growth profile is is looking relatively resilient. And then you think about the Fed being, I would say accommodative in its hiking cycle in the sense that it seems that they want to go slow. In history, when you look at fed hiking cycles that are slower and not aggressive in nature, and when you look at an economy that continues to grow, that continues to argue for the cyclical parts of the market to do well.

Kevin Gordon: So whether that’s financials, whether that’s industrials or materials, both of which are actually very central to this I infrastructure build out, that I think would still sort of argue for those sectors doing well. So that I think would be an example of where, you know, investors don’t necessarily need to feel like they’re behind in and maybe finding more exposure in sectors that they probably don’t have, you know, as much as, as tech, for example.

Caroline Woods: So if that churn that you’ve talked about becomes kind of a permanent fixture in this market, is it that investors actually have to change the way they invest, or is it that they just have to get used to bigger swings?

Kevin Gordon: I think the latter, I think change it will. And maybe maybe they’re one in the same, changing the way you invest versus bigger swings. Because if you don’t feel as comfortable with have how much, you know, the S&P 500 is exposed to this sort of shrinking number of, of mega-caps, than it probably does arguably warrant a little bit of a shift in how you construct a portfolio, whether that is down the cap spectrum into the mid-cap space or the small-cap space, or whether it is looking at ways to invest on an equal-weighted basis, that is actually, you know, over the long term equity, the S&P 500, it’s done

Kevin Gordon: quite well. It just sort of gets distorted by the outperformance that you’ve seen in the past, you know, 5 or 6 years.

Caroline Woods: Okay. What is the biggest risk to the market right now.

Kevin Gordon: So I think any any significant slowdown in the business investment channel, because mechanically that would certainly put you the GDP math is such that would probably put you into a significant slowdown for, for the broader economy, because so much is still tied to this, this build out of the infrastructure. But to the extent that has a knock on effect to the labor market, that I think would be the biggest risk if there was something out of out of the blue that we didn’t see coming.

Kevin Gordon: In terms of companies starting to really pull back on their CapEx, and if that sort of leads to a little bit of a breakdown in that and that circular nature of, of the cycle.

Caroline Woods: So it’s more the AI economy slowing down than the actual economy?

Kevin Gordon: I think so, but but increasingly it’s getting harder to differentiate and separate those two. So you are kind of fusing them together. And it’s not all dependent only on artificial intelligence and what has been done there. But I do think that we need to be wary of, not wary of maybe maybe cognizant of some potential for a slowdown in business investment, especially if we start to see the lagged impact of rates moving up a little bit higher.

Kevin Gordon: And if you don’t get a recovery in these other sectors, like housing and U.S. housing is still in its own recession, absent the rest of the economy, of course, it’s sort of living in its own house, so to speak. But I think if you don’t get a pickup in those areas and if business investment does start to slow, which is not necessarily in our, you know, our thinking or our forecast for the economy, but that, I would say, is a risk to be to be mindful of.

Caroline Woods: Yet we haven’t talked about consumer staples, consumer discretionary at all as part of your barbell approach. Is that because you’re avoiding, is that because you’re worried about the consumer losing momentum?

Kevin Gordon: Not as much momentum. But I think that from a from an affordability perspective, inflation and how much it is eating into the consumer’s ability to spend, not their willingness to spend, because there’s still a willingness to do it month to month. That consumer spending engine stays intact as long as you’ve got, you know, job growth that’s positive.

Kevin Gordon: And we live in a fully employed economy, which is still the case month to month. It’s just the case that I think from a maybe multiple fronts, especially discretionary. But also I would throw staples in to some extent from a tariff front, from a, from an input cost from especially this trickle down from diesel prices. They kind of get hit it, you know, from multiple angles.

Kevin Gordon: And that’s why consumer discretionary has been such a laggard so far this year. So we’re just not ready to sort of turn favorable on it until you can get a clearer outlook. Predominantly I would say from an inflation perspective, because I think you do need to see that inflation adjusted wage growth stabilize. But then after that, I do think you need to have more confidence from, from the broader consumer base, to be able to spend more on those discretionary items.

Caroline Woods: So unlike tech, where you have a neutral rating, you’re.

Kevin Gordon: Less.

Caroline Woods: Favorable, a lot less favorable on discretionary. And what else?

Kevin Gordon: Discretionary real estate.

Caroline Woods: Okay.

Kevin Gordon: So somewhat makes sense from a rates perspective as to why. But we really haven’t seen, we really haven’t seen conditions turn favorable yet for those two.

Caroline Woods: Okay. And one thing that I haven’t mentioned yet and we’re almost at the end here, is that today’s election day. Yes. So what should investors be watching for as results come in? Could that throw a total wrench in all of these forecasts depending.

Kevin Gordon: Oh, I mean, you know, we never pick any, any electoral, event as, as something to sort of anchor around in terms of changing your portfolio or your positioning. I would say that, you know, we’ve got reams of data this, midterm elections and the market being up, you know, in every case, if you go further than six months out, I just think that it’s an event that the market doesn’t really care about as much in terms of how much leadership will shift, you know, around it.

Kevin Gordon: If anything, I think it becomes a little bit of a sigh of relief in a clearing event because there’s so much angst heading up into it. The only thing that may be different a little bit this time, is, you know, the focus on data centers really being on the ballot. I don’t know how much of that will necessarily get filtered into a model, in terms of, okay, if the votes tally up a certain way for, for public backlash against data centers.

Kevin Gordon: What that does to, you know, semiconductors, for instance, I don’t think it’s that easy of a transmission mechanism, but I think we are going to get a lot more color on how the public feels about it, and particularly how the business community, I mean, particularly in the AI space, what the response looks like to it. So maybe that’s a little bit of a different, you know, flavor, to this cycle, this midterm election cycle.

Kevin Gordon: But broadly, we’re never thinking in terms of, you know, change your portfolio or positioning based on the, you know, the outcome of the election.

Caroline Woods: Okay. So as we think about, you know, heading into year end, do you think this is a market that can be higher by the end of the year?

Kevin Gordon: I think, but maybe marginally. I think you’re going to need to see you need to see a pretty significant comeback for, for tech. So if we’re thinking about the market in that cap-weighted index sense, you would you would need to see that, that come back from a tech perspective. But if you, if you had, you know, solid breadth profile, which actually we’ve seen a solid recovery in S&P 500 breadth.

Kevin Gordon: And if you see a little bit that optimism continue to kind of work its way out of the market. I think that sets you up maybe more in 2027 terms for a little bit of a better start to that year as opposed to, you know, the end of this year.

Caroline Woods: And just to bring it back to where we started with tech earnings, do the fundamentals justify, you know, regained momentum within tech?

Kevin Gordon: I mean was leading up until this point fundamentals have justified it. I think it’s more the flip side of it and looking out and how much the expectations have grown. That’s the part that maybe we’d put more in the risk column is if companies just can’t meet those expectations because we are in this unique environment in the cycle where, you know, typically when you go through an earnings season, the bar gets lowered and then a companies clear that far rather easily.

Kevin Gordon: You know, analysts cut their estimates and then companies can clear it when they report. We’re basically living through the opposite where the bar keeps getting raised and companies have been able to meet it. But some of the disappointment that you’re seeing and some of the stock price reactions is outside of things like just earnings, like capital expenditures and what the number looks like.

Kevin Gordon: And we’ve had different reactions, whether they’re raising or whether they’re lowering guidance. Okay. So I think that’s the that’s the metric to focus on. Okay.

Caroline Woods: I think it’s a great time to pivot to a rapid-fire round of This or That. Quick questions, quick answers, no hedging.

Kevin Gordon: Okay.

Caroline Woods: Ready? S&P 500: higher or lower by year-end?

Kevin Gordon: Higher.

Caroline Woods: Biggest market risk: AI bubble or consumer slowdown?

Caroline Woods: AI bubble. The next big market winners: AI-related stocks or companies outside of tech?

Kevin Gordon: Outside of.

Caroline Woods: Tech. More upside in 2027: mega-cap tech or the rest of the S&P 500?

Kevin Gordon: The rest of the S&P 500.

Caroline Woods: Market-cap-weighted or equal-weighted S&P 500?

Kevin Gordon: Equal-weighted.

Caroline Woods: Software or semiconductors?

Kevin Gordon: Semiconductors.

Caroline Woods: Large caps or small caps?

Kevin Gordon: Small caps. I want to hedge it, but I’m sticking to your rules: highly profitable small caps, because there’s been such a dramatic split this year between the performance of those.

Caroline Woods: That’s not a hedge. That’s context.

Kevin Gordon: That’s good.

Caroline Woods: We don’t like it. We don’t like both. U.S. or international?

Kevin Gordon: U.S.

Caroline Woods: Growth or value?

Kevin Gordon: Value.

Caroline Woods: Biggest value in the market right now?

Kevin Gordon: Highly profitable small caps.

Caroline Woods: Consumer discretionary or consumer staples?

Kevin Gordon: Depends on the time frame, but I will say discretionary.

Caroline Woods: For what time frame?

Kevin Gordon: I would say if we’re looking at least a year out, I would say discretionary.

Caroline Woods: Financials or industrials?

Kevin Gordon: Financials.

Caroline Woods: Bigger economic threat: inflation or unemployment? Inflation. Fed’s next move: hike or hold?

Kevin Gordon: Hike.

Caroline Woods: AI spending boom: sustainable or unsustainable?

Kevin Gordon: For now, sustainable.

Caroline Woods: Stocks or cash for the next six months? Stocks. Buy the dip or wait for a bigger pullback?

Kevin Gordon: Oh, buy the dip.

Caroline Woods: And the most overlooked sector heading into 2027?

Caroline Woods: Materials. And in a few words, describe how you’re feeling about the market heading into year-end and into 2027.

Kevin Gordon: Cautiously optimistic, with certainly a focus on how much hotter inflation gets from here.

Caroline Woods: And finish this sentence. The biggest risk to the bull market is.

Kevin Gordon: A further breakdown in tech.

Caroline Woods: All right. Well what does that look like. Like a down day or how many.

Kevin Gordon: I think breadth for the Nasdaq not recovering, and basically a setup like you saw heading into 2022. Most of the weakness that started in tech was really kind of a precursor to what happened with the rest of the market. But importantly, in 2022, it was an earnings/valuation bear market. So that was more of a cyclical reset as opposed to a signal that there was going to be some massive recession.

Caroline Woods: Okay. All right. Kevin Gordon, always a pleasure. Thank you so much. Really appreciate it. That’s Kevin Gordon, head of macro research at Charles Schwab. If you enjoyed this Street Talk, check out our full interview with Dan Ives. We hit on all the major tech stocks, and he gives his top picks and the ones he’s avoiding. And if you’re liking this content, be sure to like, comment, and subscribe.