Diversification will remain key heading into 2021: strategist

Charles Schwab’s Chief Investment Strategist Liz Ann Sonders joins Yahoo Finance Live to discuss her market outlook for 2021, and why she thinks the economy has more rough terrain to traverse.

Video Transcript

JULIE HYMAN: Well, our next guest calls that vaccine or vaccines a light at the end of the tunnel but we're still in that tunnel. Liz Ann Sonders is joining us now. She is Charles Schwab Chief Market Strategist. Liz Ann, it's always great to see you. And you're out with an extensive note looking ahead to next year and what we can expect. And one of the things that we can expect is a vaccine or vaccines but it could be rocky in the interim. It doesn't look like it's necessarily going to be rocky for stocks in the very short term. What do you think?

LIZ ANN SONDERS: Well, obviously from an economic standpoint, the virus represents a pull forward-- I mean the vaccine represents a pull forward of a return to maybe more normal economic growth but the virus and the resurgence of it and the impact it's having, some of the lockdowns we're seeing across the country, is having the effect of pushing down economic growth. Now the market has done an extraordinary job really since the beginning of this crisis of looking across the chasms, however large, created by the virus sort of to the other side.

But I think near-term the biggest risk in the market is actually a function of what's happened in the market, the huge gains that we saw, especially in areas that had not been the pandemic winners in November, small caps having a record month. And what we saw in conjunction with the initial Pfizer vaccine news was a shift from sentiment having really only been frothy in certain pockets of the market, in the single stock options market by the newly minted day traders, and it became pervasively optimistic. So I think that enthusiasm, complacency, euphoria, whatever term you want to use, in and of itself represents a bit of a risk in the near term and could mean that even a fairly minor catalyst, which could be economic data, might be enough to put us into another one of these pullback phases that we've had three times since the low in March.

BRIAN SOZZI: Liz Ann, just staying on that topic of the market perhaps being too frothy. Is it too frothy relative to where you see corporate earnings going, let's say in the back half of next year?

LIZ ANN SONDERS: Well, it's funny, corporate earnings obviously are the denominator in your traditional PE equation and there's no question the forward PE is elevated relative to history, it's in line with where we were back in 2000. For some of the high momentum stocks, the big five, the valuation is not [INAUDIBLE] underlying fundamentals are much stronger now than was the case back in 2000. But valuation we think of as this fundamental indicator because it's got quantifiable components to it but the reality is valuation is as much a sentiment indicator as anything else. So I think the reason why we've seen such multiple expansion is tied into the enthusiasm that we're seeing in many sentiment measures.

I think earnings look fine into 2021, especially starting in the second quarter when the comps get very easy. But we're going to need to see that stream of earnings persist because using things like 0% interest rates as a basis for justifying elevated valuations, that doesn't persist forever. But as long as sentiment stays elevated, it probably means valuations stay elevated.

MYLES UDLAND: Liz Ann, you don't have a price target in the note but I think there's a suggestion in there that's very interesting on the index level when you look at the composition of leading sectors next year. You outline some of the dynamics around how much of the market cap is tied to the big five stocks versus the rest of the index. I'm wondering if you can kind of talk through for our viewers that thought as we look at next year's potential leadership type groups?

LIZ ANN SONDERS: Sure. And we don't do year end price targets. Frankly, I think that that's an incredibly silly exercise. I'm not sure I understand the value of it, especially [INAUDIBLE] bolsters how the markets are and the folks that do it how often they have to change those targets throughout the year.

But in terms of the concentration that really hit a peak in early September, at which point the big five, so Apple, Microsoft, Amazon, Google and Facebook, had a 6,200 basis point spread in year-to-date performance over the other 495. At that point, which was the first sort of launch to new highs for the S&P and NASDAQ. Those five stocks on average were up 65% and the other 495 were only up 3%. I actually think that answers the question I get all the time, which is, is the stock market disconnected from the economy? That was sort of the reality at the time, a small subset of not just survivors but thrivers and still a lot of pain under the surface.

Then we've had these series of rotations since early September and they've had growth to value flavor, they've had defensive to cyclicals, they've had COVID winners to COVID losers, it's been at the sector level. And I think heading into next year I think we'll likely see the market continue to try to find some leadership in the more cyclical areas but it's going to need that sustainable improvement in economic growth. In the meantime, I think that those rotations will happen in fits and starts and the best strategy for investors to take is not to try to anticipate them in advance but maybe rebalance more frequently and use those moves and give you the opportunity to sort of trim into strength in certain areas and add into weakness as opposed to trying to anticipate those rotations in advance.

JULIE HYMAN: And you sort of illustrated that in your note, Liz Ann with what you called a quilt, which I quite liked, which was showing the different sectors, showing different leadership at different times in different colors as we saw that sort of rotation go through. Do you think that that sort of diversification that you're talking about should also go for different asset classes when you're talking about the periodic rebalancing?

LIZ ANN SONDERS: Absolutely. In fact, the normal way to show a quilt like that and we have a version that's copyrighted, is asset classes. So US stocks, international stocks, components of the bond market, treasuries, corporate bonds, high yield, cash. But I decided to take a twist on it for the '21 outlook and look at the sectors on a monthly basis. But I actually think that diversification becomes an easier sell and arguably already has been in a year like this year. We've been in this mindset of eh, why be diversified, US equities are the only game in town. Even this year, the total return on long bonds and medium term bonds, 30 year treasuries, 10 year treasuries, the total return, not the yield, the total return, is actually better than the total return on the S&P 500.

You've had some non US markets outperform. And we think as we head into 2021, diversification will pay dividends not just within an asset class like US equities across sectors, but across asset classes, including international, non US. Not that they're going to take over the leadership and leave the US in the dust but I think correlations coming down means it will be an opportunity to actually add some value in portfolios through that long held discipline of diversification that has maybe justifiably been shunned in the last several years.

JULIE HYMAN: Liz Ann, it's always great to get your thoughts, especially as we look ahead to 2021. And I also love, forget about the price targets, it is sort of it's a tough game to strategize.

LIZ ANN SONDERS: I get it.

JULIE HYMAN: Liz Ann Sonders, thanks so much. Charles Schwab.

LIZ ANN SONDERS: Thanks. My pleasure.

JULIE HYMAN: Chief Market Strategist. Appreciate it.