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Key reasons to be cautious on equities going into Q4: Portfolio Manager

Ellen Hazen, Portfolio Manager at F.L.Putnam, joins Yahoo Finance Live to discuss outlook for equities in Q4, stocks to focus on in the current market, and outlook on the debt ceiling.

Video Transcript

ALEXIS CHRISTOFOROUS: All right, let's continue our markets conversation and bring in Ellen Hazen, Portfolio Manager at FL Putnam. Ellen, always good to see you. So you know what, look, I know this is the last day of the third quarter. So that's already in the rearview mirror, right? Let's look ahead to the fourth quarter. What are your expectations? Are you bullish here and can we rally into 2022?

ELLEN HAZEN: Thanks, Alexis. We are concerned and a bit cautious on equities going into the fourth quarter for four key reasons. First of all, earnings are decelerating. And with valuations where they are, equities tend not to do all that well when earnings are decelerating. This is particularly true in some areas like consumer discretionary. So we're looking for year-over-year earnings growth to be slower in Q3 and then again in Q4.

The second reason we're cautious on equities and believe that you need to be selective is that breadth continues to weaken. If you look at the S&P 500 back in August, you had 90% of the names in that index above their 200-day moving average. And even as the index was making new highs in early September, that had dropped down to 80%.

So you didn't see the full participation. And now as of a couple of days ago, it was only 70%. So that breadth is quite concerning and continues to be a warning sign for us. The third reason we're selective on equities and which ones to own, and a bit cautious in general, is because, of course, inflation. You've seen inflation be stubbornly persistent over the last several months. It looks, as you said earlier, Jay Powell said, that it may not be transitory after all.

And the number of mentions of inflation in earnings calls in Q2 was more than double that of Q1. On top of that, it's broad. It's labor. It's fuel. It's electronic components. It's logistics. It's freight. It's steel. It's other input costs.

And so when you look at the ratio of PPI to CPI, it's concerning, and it means that margins are likely to continue to be crimped, hence, that's why the earnings are decelerating. And then the final reason that we think you need to be selective is that the equity market has been going through a rolling rotation all year long. First, we had the reopening plays doing very, very well, but that only lasted just over a quarter.

And if you look at the second quarter and especially the third quarter, you've seen growth reassert its dominance, but then it's reversing again in the last few days. So what we think you need to own in a time like this are companies that benefit from inflation and benefit from rising real rates. And those are going to be financials, real estate, real assets. But we're cautious into the rest of the year.

ALEXIS CHRISTOFOROUS: OK. So you just outlined for us some places investors might want to be here mid-cycle, given the trends that you just ticked off. Can you get specific with us, tell us which stocks within those groups you like right now?

ELLEN HAZEN: So within financials, we like the banks, because the yield curve has been steepening. As you know, the yield curve was inverted a year ago. And now it is up to 125 basis points between the 2 and the 10-year. And so large cap banks tend to do very well with a steeper curve.

We like the high quality companies-- JP Morgan, Bank of America. In both cases, you have fairly inexpensive valuations on price to earnings, with both of them trading around 14 times. And on price to book, they're sort of fairly valued at 2, maybe 2 and 1/2 times price to tangible book. But they're growing earnings high single-digits, low double-digits. So within the financials, that's what we like.

We also like REITs and particularly CBRE-- CB Richard Ellis, which is a real estate broker. So they make money on volumes and transactions. And they're a little bit different from a traditional REIT, but if you look at their business this year, the estimates have increased substantially. And we think that one still has room to run.

ALEXIS CHRISTOFOROUS: What about all the noise, if you consider it to be noise, that's happening in Washington right now, and talk about the US possibly defaulting on its loans for the first time ever. Are clients concerned about this? And how worried are you?

ELLEN HAZEN: Of course, if it happens, then it's a big deal. Right now, we believe that, as has been the case in the past, it will prove to be transitory and ultimately political posturing by both sides. Both sides are using it as a wedge to try to drive negative public perception of the other side.

But it would be fairly catastrophic if the US were to actually default, and so we believe that Congress will come to its senses and not permit that to happen. If you look at how the market looks at it, then back in 2011, back in 2013, the market looked past it pretty quickly. And we think that's likely to happen this time too. But I sure do hope that Congress can get its act together.

ALEXIS CHRISTOFOROUS: Yeah, we all do. What do you think is the greatest threat to the market in the fourth quarter? There are lots of them lurking out there, which one do you think is the biggest one?

ELLEN HAZEN: I think the biggest one is simply valuation. You have the S&P was up 20% earlier this year, now I think it's maybe down to only up 16%. But that's pretty high on earnings that are decelerating. And so what might cause that to devalue and multiples to compress-- clearly, real rising interest rates. And that is happening, and that particularly hurts the large cap tech companies because so much of their growth is out in the future. And so as we see inflation continue and, therefore, real rates rise, in that case, we'll see continued multiple compression for some of the big cap tech stocks that make up so much of the market that they drive the overall market.

ALEXIS CHRISTOFOROUS: All right, Ellen Hazen, Portfolio Manager at FL Putnam, good to see you. Thanks so much.