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Stocks are 'priced for perfection': Portfolio manager

The "magnificent seven" have powered the stock market's gains this year. Brandywine Global Portfolio Manager John McClain tells Yahoo Finance Live those stocks have been driven by AI and China relations. "If either one of those things start to cool a bit, you will see a meaningful pullback," McClain says. Watch the video above to find out why McClain says stocks are currently "priced for perfection."

For more expert insight and the latest market action, click here to watch this full episode of Yahoo Finance Live.

Video Transcript

RACHELLE AKUFFO: And obviously, you have the Magnificent Seven which has really been driving a lot of the gains that we've seen so far this year. Do you think a lot of that focus and, as we sort of seen that progress, sort of spread throughout the broader markets? How much of that is going to, perhaps, change at some point? Are we going to be due for a correction?

JOHN MCCLAIN: Well, look. You haven't had a strong breadth in the market. You have had seven companies. And a lot of that's driven on AI. A lot of that's driven on China relations. So if either one of those things starts to cool a bit, you will see a meaningful pullback.

And I think, really, what we're saying is when you look at equities, they're priced for perfection at this point in time. You're trading at a 20 times PE with T-bills well north of 5%. So you've got the earning earnings yield on the S&P 500 well below where T-bills are. And that's typically not what we see in this market.

RACHELLE AKUFFO: And what do you think that markets should be pricing in at the moment, when you look at some of these recession risks ahead? Depending on what the Fed does, if they do decide to hike again, hike again in November versus, say, just stay the course and stay data dependent and let the medicine take its course?

JOHN MCCLAIN: Yeah. You know, it's a tale of two different marketplaces. When we look at investment grade and high-yield corporates with spreads reasonably tight, that still actually makes sense to us because we think companies have dynamically changed over the past decade and really don't face particularly in the higher credit part of the marketplace, don't face meaningful default risk.

While interest costs are going up, that's fine for these companies. It just really creates a lack of free cash flow that goes to equity holders through dividends or share buybacks. Now, the equity markets is certainly a little bit different here. I mean, I think it's, like we said, it's pricing in a soft landing.

And it's really ignoring the fact that the cost of capital has gone up by 400 or 500 basis points for companies over the past 18 months and that management teams' capital allocation policies are really focusing more on debt repayment and living within interest coverage ratios as opposed to shareholder friendly activity. So we see the equity markets as being particularly overvalued in the US.