Lori Calvasina, Amy Wu Silverman, Ben Fisher

Lori Calvasina

Today's format is a little bit different from the typical Markets in Motion podcast. We're going to spend the next 15 to 20 minutes having a chat about the big things you need to know from our recent conversations on the outlook for equities. Ben will be our moderator. Now, before we jump into it, a quick reminder that I voting season is open and if you found our work helpful this year, we hope you'll cast a ballot for me, Lori Calvasina, in the portfolio strategy category.

Now let's get into it and over to Ben.

Ben Fisher

Great. Thanks, Lori, and thanks for having me, though. I was hoping this was on video as I told my kids I'd be on TV and I bought a new shirt and shaved, but probably better for everyone than I am not on camera.

And before we dig into the good content, I would like to reiterate the support for Lori in II. I know like Amy and I, she has young children and is constantly on the road digging up incredible content. So she is more deserving than anyone I know for the vote.

So speaking of that content, let's discuss some of the stuff coming up in your and Amy's meetings and just our overall conversation on the market.

I'd say over the past few weeks, the market has once again gotten very concentrated, specifically Semis and AI trades. We've seen some volatility in the software growth sector, and that has pushed the market to be even more concentrated, if that's possible. So a question for both of you on this is, I know you've both done work on this and have had a lot of conversations.

First for you, Lori, I guess just generally do you think market concentration is unhealthy? And in your conversations with investors, is there a lot of angst around this?

Lori Calvasina

But it's still pretty prevalent. You know, the question of whether or not it's unhealthy, I think there was a view that it was, there was a lot of skepticism around, the idea that the market could possibly keep pushing forward. But we were hearing that six months ago and we're still doing pretty well as I've looked back at the data.

I don't think there's anything unhealthy about concentration in and of itself. If we look back historically, it tends to happen when markets are nervous. These big spikes in concentration and sometimes it's before a big problem in the market, sometimes it's during and sometimes it's after. And if you look at valuations, there has been a big gap that's developed between the so-called MAG seven and the rest of the market.

I prefer to actually look at the top ten. You're trading at around a 25 times P/E multiple and that's down a little bit from 28. And guess what, 28 at least on the median P/E was the pre-COVID high. So we're bumping up against that the rest of the markets around 16 times. I think that's exciting. I don't think that's unhealthy.

They're getting thrown out of the bucket and investors are starting to look at other things.

Ben Fisher

So maybe just give like a brief history of how this skew has developed. Why should equity investors, who will probably be the majority of people listening here, why should they care about this skew and what is it telling us right now?

Amy Wu Silverman

Sure. So first, I like your shirt and I've been on the road with Lori to many countries and many cities, and I'm constantly in awe of her passion for the markets and her photographic knowledge of financial history

So I, too, must make my II plug here. But, you know, look, I’ve covered the derivatives markets for 20 years. And to me, the post COVID volatility regime really is its own creature. As Ben said, you know, skew is something that we constantly look at in our markets. But just to define what that means, it's simply this idea that for most of financial history put options so you're buying downside protection.

Folks were far, far more concerned about the right tail grab. And we saw that in momentum. We saw that in FOMO. These are things that we throw around as catch phrases, but you actually see numerical evidence of that in the options market. And what I would tell you is it's doing two things. So Lorrie says, look, it's not unhealthy, but it is doing two things to the volatility market.

The first is it's making correlation levels look very low. And the second thing it's doing is it can also make volatility levels on the index level look artificially suppressed. And so there are these violent rotations that may be occurring underneath the surface, but it looks very calm on top. And so we kind of call that the paddling duck market.

But it's essentially to say there actually is a lot more concern than you may be seeing from headline numbers like the VIX.

Ben Fisher

Thanks, Amy. And just a follow up question, Lorie. So I know you don't think it's unhealthy necessarily, but obviously everyone, the majority of the investor base can't own the MAG seven stocks, whether they're small and mid-cap investor or even a large cap investor.

The question we get a lot obviously, is still what it's going to take for the market to broaden out again, what it's going to take to see that rotation again. I know your love is small cap so it's a question near and dear to your heart. But what do you think it is? Do you think it is as simple as waiting for the Fed cut that we've been waiting for so long if it ever comes, or is there anything else that can act as a catalyst for you?

Lori Calvasina

So I think it's a great question. And we've gotten some hints of it right, because we've started to see the big mega-cap growth again, MAG seven and top five, top ten, whatever it is, we've had some wobbles right?

It's fighting back as we're taping this podcast, but we've seen some wobble. So what have generated those wobbles and what's generated this bounce back?

One thing that I've noticed that's a little bit weird in the data is that post SVB and that regional banking crisis, we've seen this really, really odd trading relationship develop such that when ten year Treasury yields are rising, the top five names in the broad market and the S&P, the top ten names, if you look at them relative to the rest of the market, that relative performance trade is just moving in sync with ten-year Treasury yields.

So we've seen a little bit of a lift in interest rates recently that's come alongside another bout of, hey, guess what, we're not getting those Fed cuts nearly as soon as we thought we were. And so that seems to have reinvigorated the gross trade. I think part of it is that part of the market has just much safer balance sheets.

I think part of it is a reflection of growth fears down the road. But I do think at the end of the day, you do need to get closer to the cuts. Right? And we at least need this ten-year Treasury yield pressure to come off. We can't really be in a rising rate environment for the rotation trade to work.

Fast forward to January 1.3%, then move to where we are today 2.4%. That's right on the cusp of average averages about 2.6. And historically, when you're above average in GDP, that's when values, cyclical and small cap outperform. If you're below average, you're sort of stuck in economic purgatory. That's when growth mega-cap, large cap, secular defensives tend to outperform and we're stuck right on the cusp of it.

We made a ton of progress that helped get the rotation of trade going, but it just couldn't continue as we stalled. The other thing we've seen recently is there's been this whiplash in terms of earnings growth enthusiasm for those big names versus the rest of the market. Throughout all last year, more upward revisions for the top ten names in the S&P or big cap growth stocks in the rest of the market.

We got to this last reporting season. All of a sudden, the rest of the market started to see upward revisions. There was a little bit of rationalization and catch up that lasted until we got to retail reporting season when all of a sudden, when we had some of these AI related names report you got more upward revisions to earnings forecasts again in that kind of biggest mega-cap growth cohort.

So we've just seen it go back and forth and that earnings growth dynamic seems to be dictating which part of the market is doing better. Again, it's very rational, but we basically just need the earnings growth expectations and the rest of the market to get going again. And I do think it's dependent upon economic expectations getting reinvigorated again.

Ben Fisher

Yeah, unfortunately, it seems like this week has been a growth slowdown week with the ISM. We had jolts today, so looks like that's maybe on delay a little bit. Again, until we get more clarity.

Just switching gears, another recent topic that I know is near and dear to your heart Amy is the retail investor. The meme craze, we will leave the specific meme stuff out of it, but it is important.

The retail investor dynamic has become more of a feature since COVID, and I think we've all been surprised how much they've stuck around. I think post-COVID with the stimulus, or the stimis as they like to say, it made sense as to why retail activity was so elevated, but it just doesn't seem to go away.

And now the economic environment just doesn't really make sense of why there is such a feature. Some of the stats that we get from our traders in terms of the amount of the percentage of retail, the volume that's being traded from retail is quite astounding. What do you make of this and what does it mean for the broader market? Why should institutional investors care about retail?

Amy Wu Silverman

You know, when the first meme frenzy came about, I remember the conversations we were having with institutional investors was that this was kind of a storm in a tea kettle, something to kind of not pay attention to. But what happened was it wasn't the individual stocks that were problematic. Obviously, if you're not long or short the individual stocks, then arguably in theory, you don't have to care.

But they became larger and larger percentages of different benchmarks. And so I would have these conversations with investors who initially would be like, whatever, it doesn't matter. But then they would start to drag their benchmark because these stocks became such enormous components of them and they didn't have them in their portfolio. And what's interesting is when you think about the AI craze, this is actually exactly the same thing that's happening on a larger scale.

So this time around, I'd say for institutional investors, they're paying attention to two things. The first is they're looking at more right tail hedging for their benchmarks. What do I mean by that? So even if they're not necessarily long, these individual names that are part of the meme frenzy, they are very concerned about their growth within the benchmark itself and that drag I mentioned. So they're doing more of these right tail hedges that we've seen, which are call options on certain benchmarks.

And the second thing I would say is this is still a very strong sentiment indicator. Retail demand in call options themselves, which, my favorite word, skew inversion, when that called demand starts to outweigh that put demand, has actually been a pretty decent leading indicator to where we are in terms of froth in the market.

And that hasn't changed. It's just actually expanded to different stocks. And so while we initially saw it most severely in meme stocks, it actually applies a lot of different stocks as well.

Ben Fisher

Lorie, before we jump away from the retail topic, I know a big indicator for you is the AAII sentiment survey, which represents individual investor sentiment. I know that's a big guiding post for you.

So where are we in that right now? Is it too bullish? Too bearish? Somewhere in the middle?

Lori Calvasina

So you're right, it's something we've used over the last, I would say, year and a half. I've used it my whole career, but it's really been helpful the last year and a half at navigating these short- term moves, bottoms and tops.

And right now it's getting really, really close to where it was to start the year and where it kind of hovered until we got that 5% draw down. It's really close to where it was in late July, early August, before we got that 10% drop in the market. And look, I think sentiment isn't the worst it's ever been, right?

If you're looking at this, it's been hovering just below one standard deviation above the long term average. And in August, and to start the year, it kind of hit that plus one standard deviation mark. And that's typically a prepare for a short-term drawdown type signal. So that's kind of where we are. I just don't think sentiment got washed out enough with that 5% drawdown that we saw.

So it's, you know, giving you arguably an even worse signal from the institutional side.

Ben Fisher

Yeah, it makes sense even seem to even more concentrated into one sector now as well, given the kind of semi ownership I've seen as well. So finally, since we are at the RBC Global Energy, Power and Infrastructure Conference, which by the way, is record attendance.

I would also like to make a plug for our all-star global energy team for institutional investor. It's it truly is a flagship, an amazing conference that you should come to next year if you are not here. But you know, since we are here and we just love the both of you, I know I've done work on the energy and utility sector, so I would love your view on the energy sector.

Lorie is specifically maybe geared towards utilities, which has come up as kind of a sneaky AI play with just the data center build out. I'm wondering if you're hearing more from generalists that want more exposure to the sector and then I'll pass along to Amy.

Lori Calvasina

It's a great question, you know, and I ducked into an air panel for the that are utilities analyst had put together today and it was packed they were standing room only I didn't end up staying because there was nowhere to sit and really even stand and I can't remember the last time I saw a utility presentation that was standing room

I think that's a testament to the investor interest and the utility space right now. Just based on again, on this idea, as you mentioned, of it being a derivative play on I and I know I was out marketing a few weeks back when all the utility companies were reporting and I first started hearing about it, you know, from clients.

And they were really just buzzing about how on all these earnings calls, the utility companies were talking about the boost from air demand and contrasted with what we heard early in the reporting season when all the financial services companies were coming out and saying, hey, we're working on this, but it's going to take a few years for it to hit the expense line.

So it was a great illustration how the air theme is alive and well and investors’ minds. But it's not static, right? I mean, people are constantly looking for new ways to play this theme. And I think if you want to trace that back to the utility sector, we had seen nice valuation profile developed for the sector.

So this is one that I think I was market weight most of last year. I put an overweight on back in January. I will tell you A was not on my bingo card for this sector, but we did notice that the valuation profile had just improved. We were concerned about some chop in the market. We like the defensive profile.

It's one that should in theory benefit from a rotation to value, just given its presence in those benchmarks. And our analysts have been reasonably constructive. So I think the AI development just came along at a good time when there was some undervaluation to be exploited and the market did what it always did, sniffed out the story, reacted and came in and beat it up.

So we're still overweight there. We still like the sector. We have noticed that if you look at sector flows and we use the EPFR data and look across all the major sectors, utilities has gone from being very negative to slightly positive in a hurry. It doesn't look overextended to me. But it has been interesting just to watch how quickly that money has shifted.

You know, if you think about energy, I know this is a sector that had a nice move earlier this year. It stalled out a little bit recently in terms of relative performance. On all my metrics, it still looks pretty good. And again, I'm a little bit more long term with the sector calls, but I still see nice valuations improving earnings revision trends, geopolitical angst, I think is something that we're not going to say goodbye to anytime soon if you listen to Helima, who's done some fantastic work just on all the geopolitical conflicts that we've seen emerge around the world

And, this is a little bit more boring. But if you look at the dividend yield of energy, it's very high relative to history and it's very high relative to other sectors. And we're sitting here at a time, given the move in Treasury yields, that very few stocks in the S&P have a dividend yield in excess of the ten-year Treasury.

And going back to the more calm part of retail. But many individual investors do look to yield oriented stocks to boost their portfolio returns over time. So we still like the energy story. We're not trying to play every twist and turn there, but admittedly, you know, utilities is kind of the more exciting one at the moment.

Ben Fisher

Amy, I know you had an interesting analysis to your Sharpe ratio analysis, and it was actually an interesting finding for the energy sector in general. So maybe first before we delve in your findings and share anything you found interesting there, maybe share a quick tutorial for why it matters and what it showed for the energy sector.

Amy Wu Silverman

Sure. So I like to think of the Sharpe ratio in terms of Disney World. So, you know, I mean, everyone says you're supposed to take your kids to Disney World, right? But you kind of have to look at that return of like how much that was worth it against what your next best alternative was. And, you know, if mine is just free pool at Grandma's, that's a pretty good alternative.

And then you also have to consider you take your kids to Disney World, they missed their nap and there's tantrums and then that's your volatility. Okay, so your Sharpe ratio is really simply your return of going to Disney World against your next best alternative adjusted for how much tantrum your child is going to have, it's your expected return over your risk-free rate divided by your volatility.

And essentially, when you quantify that across all stocks, that gives you a numerical understanding of risk reward. So reward per unit of risk in the market. And the reason we do this is the one big sea change in the market is that the risk free rate is a real rate now. Right? We had zero interest rates for a really long time.

We had negative interest rates in some places. But now if you can get five point whatever percent in your money market account, then you better be doing really well in your stock to make you want to do that versus your next best alternative. And so when we look at that quantitatively across sectors, it actually shows that energy is a top sector from a sharp ratio perspective when we aggregate all the weights and the energy sector.

And that's really interesting to me because, look, as Lori knows, I'm not a fundamental person. We do everything quantitatively and systematically. And so I go by what the data says. And right now it continues to say that energy is one of the more attractive ones on a sharp ratio basis. And we use consensus changing price targets over 12 months as that expected return makes sense.

Ben Fisher

Yeah, it definitely, qualitatively seems like the risk reward for the companies that presentations that I'm sitting in is certainly positive based on their comments. So that's all I got. See you both on the road some time and some random Midwestern city. And thank you again for having us.

Lori Calvasina

Well, thank you both for doing this. I've done it this podcast Markets in Motion at least for a few years now, and it's been one of my very nerdy dreams to be able to do a conversational podcast. And I can't think of two better people to do the first one.

Amy Wu Silverman

Well, thank you.

Lori Calvasina

That's all for now. Thanks for listening and be sure to reach out to your RBC representative with any questions.