Lis­ten: http://media.bloomberg.com/bb/avfile/vN676xOKjguE.mp3

(This is not a legal tran­script. Bloomberg LP can­not guar­an­tee its accuracy.)

LIZ ANN SONDERS, SENIOR VICE PRESIDENT/CHIEF INVESTMENT STRATEGIST, CHARLES SCHWAB AND CO. INC, IS INTERVIEWED ON BLOOMBERG SURVEILLANCE

OCTOBER 20, 2011

SPEAKERS: KEN PREWITT, BLOOMBERG SURVEILLANCE HOST
CAROL MASSAR, BLOOMBERG NEWS
LIZ ANN SONDERS, SENIOR VICE PRESIDENT/CHIEF INVESTMENT STRATEGIST, CHARLES SCHWAB AND CO. INC

8:02

KEN PREWITT, BLOOMBERG SURVEILLANCE HOST: We're going to get another look at earn­ings and other things hav­ing to do with equi­ties with Liz Ann Son­ders from Charles Schwab and Com­pany. Liz Ann, good morning.

LIZ ANN SONDERS, SENIOR VICE PRESIDENT/CHIEF INVESTMENT STRATEGIST, CHARLES SCHWAB AND CO. INC.: Good morn­ing, everybody.

PREWITT: What is your take on earn­ings sea­son so far?

SONDERS: I think Mike is right. So far, we have had a pretty decent sea­son. It looks like we will beat expec­ta­tions by a cou­ple of per­cent. The for­ward guid­ance has not been dis­as­trous and it may reflect just that ana­lysts got quite skit­tish, par­tic­u­larly back to August, and prob­a­bly more than suf­fi­ciently low­ered expec­ta­tions. So we've got the bar a bit lower and there­fore the abil­ity to hur­dle that becomes greater.

CAROL MASSAR, BLOOMBERG NEWS: Liz, you know ear­lier this month, you wrote reces­sion fears have mounted, but the pic­ture is still mixed and it is not yet con­clu­sive. Do you feel like we have any more clar­ity almost a month later here?

SONDERS: Yes, I think we have more clar­ity that sug­gests reces­sion will be avoided. We have got­ten both ISM rat­ings on the ser­vices and man­u­fac­tur­ing side, both bounced up. Even some of the regional sur­veys, although the head­lines may not have looked great on the sur­face, if you look down into the details they were much bet­ter. Chain store sales, retail sales, con­struc­tion spend­ing, even some of the hous­ing starts and per­mit num­bers were not bad. So the list goes on and on.

And the funny thing is is I have been against the reces­sion case for the last cou­ple of months now. And some of the push back I have got­ten is what are you see­ing that nobody else is, how can you think we have a strong econ­omy if the only two options for the econ­omy are reces­sion or strong growth? I don't think we are going to have strong growth, but a kind of mud­dle through envi­ron­ment is dis­tinctly dif­fer­ent than a reces­sion. And that is what I think we are going to get.

PREWITT: Well, when you say mud­dle through, what is that — two per­cent GDP?

SONDERS: I actu­ally think we could get close to three per­cent for the third quar­ter. I think we have had some coiled spring effects that came from the incred­i­ble weak­ness, much of which was cycli­cally dri­ven in the first half of the year, not the least was the spike in energy prices.

So every $10 increase in oil prices shaves about a half a per­cent­age point off of GDP. So if you do the math, you could get a per­cent and a half of GDP growth purely from the spike we saw in energy prices. So you've got the com­mod­ity price cycle mov­ing in the oppo­site direction.

The other inter­est­ing thing is that when we saw those down­ward revi­sions to prior GDP, those were down­ward revi­sions to real GDP. Nom­i­nal GDP was actu­ally revised up. It was just the defla­tor that was higher than orig­i­nally thought.

Now, I think we have the oppo­site affect, where we are start­ing to see a falling defla­tor because of falling infla­tion, which means even if nom­i­nal GDP is not very strong, we are going to be sub­tract­ing a lower defla­tor, which means we might get a lit­tle bit of a boost to real GDP. So I think third quar­ter might be okay.

HOLLAND: For the lis­ten­ers, Liz Ann, the record is that you are not exactly a Pollyanna. You've given some very opti­mistic com­ments, yet in 2008, you were among the few peo­ple who iden­ti­fied the source of some very sig­nif­i­cant prob­lems and actu­ally proph­e­sied the melt­down. You also then called the turn. Where are we today with equity prices rel­a­tive to your rel­a­tively opti­mistic view?

SONDERS: Well, thank you for your very gen­er­ous and kind comment.

HOLLAND: You did (inaudible).

SONDERS: So I think that at an 11 mul­ti­ple on for­ward earn­ings, the mar­ket is I think obvi­ously cheap. The con­cern though is what the path is for the denom­i­na­tor E. So given that 2012 esti­mates are still in ques­tion, and I do think that if I am wrong about avoid­ing a reces­sion and we do go into one, you could sug­gest that esti­mates have not been cut suf­fi­ciently. So maybe we are in a lit­tle bit of a hold­ing pattern.

That said, I think rel­a­tive to a 16.9 long term median for for­ward earn­ings and the 11 where we are right now, you have built in a pretty healthy cush­ion. And I think the 12 per­cent nine day rally we saw may reflect some­thing that I think is being under appre­ci­ated, which is, yes, there are still neg­a­tive tail risks, most of which prob­a­bly have a Euro­pean fla­vor to them.

But I think that there are also pos­i­tive tail risks because the expec­ta­tions bar has been set so low, you get even the slight­est bit of bet­ter news, whether it is on the domes­tic econ­omy or maybe in a month or so what comes out of the super-committee or Europe, you can have as fast a rally as you've had some of these sell offs. And I think we were reminded of that with the big rally that we saw into last week.

HOLLAND: Could you give us any insight into what the Schwab clients are doing as a group now?

SONDERS: You know, it is inter­est­ing, one of the ways that we see activ­ity is by look­ing at the dif­fer­ence between what our Schwab clients who kind of do it them­selves, do-it-yourself investors, or indi­vid­u­ally dri­ven ver­sus those who have some sort of advised relationship.

And inter­est­ingly, those that have had an advised rela­tion­ship, where let's assume there is a lit­tle bit more dis­ci­pline around the man­age­ment of the money, there is more strate­gic asset allo­ca­tion, that has been a cohort that has expressed much less skit­tish­ness. They have not kind of pan­icked out or pan­icked back in. And I think that it goes to the notion of that dis­ci­pline, of rebal­anc­ing and diver­si­fi­ca­tion. All the things that are so bor­ing to talk about on shows like this.

But if you really heed them and adopt them as part of your phi­los­o­phy, you end up being able to kind of weather the emo­tional storm of what we have expe­ri­enced in the last sev­eral months more than if you are — for lack of a bet­ter way to describe it — wing­ing it.

PREWITT: What sort of shape are con­sumers in, and what is the bear­ing on the hol­i­day sea­son for retailers?

SONDERS: You know, con­sumers are in much bet­ter shape than they were three years ago. They are cer­tainly not back to full health.

But the finan­cial oblig­a­tions ratio as one proxy for that is at about an 18 year low right now. If you look at debt ser­vice ratio, con­sider there being three zones of debt ser­vice — very high debt ser­vice, which is where we got to back in 2008; sort of a neu­tral zone; and then low debt ser­vice zone in which nor­mally the econ­omy does quite well. We are actu­ally about to breach below into the low debt ser­vice zone because of just of how her­culean the efforts have been on the part of the pri­vate sec­tor to pay down debt and boost sav­ings rates, which has been going on for three years now.

Of course, the prob­lem is we are now launch­ing that for the pub­lic sec­tor very nec­es­sary. But the pri­vate sec­tor has been doing it for about three years right now. And I cre­ated an index sev­eral years ago that I called the con­sumer stress index. It is a take on the mis­ery index, but it has many other com­po­nents to it besides just the infla­tion rate and the unem­ploy­ment rate. And that has actu­ally moved down into pos­i­tive ter­ri­tory, mar­gin­ally pos­i­tive ter­ri­tory, mean­ing down, mean­ing less stress.

So I think what we are see­ing, and I think it is show when you look at the dif­fer­ence between con­sumer sen­ti­ment or con­fi­dence read­ings and con­sumer spend­ing num­bers, we have never seen a gap this wide. So we are expe­ri­enc­ing right now the what peo­ple say and what peo­ple do are dif­fer­ent things. That doesn't mean the con­sumer is going to boom by any means, but con­sumer spend­ing can prob­a­bly track nom­i­nal income growth, which is a pos­i­tive num­ber. It is not a boom, but it is a pos­i­tive num­ber and should help keep GDP afloat.

MASSAR: Liz Ann, how com­fort­able are your investors — Schwab investors — with the volatil­ity that is out there? I am look­ing at images of Greece and else­where around the world. I mean how com­fort­able are your investors with this? Are they kind of get­ting used to it com­ing off of the crisis?

SONDERS: I think some prob­a­bly are, but it is still a mea­sure of angst that isn't going away any­time soon. I wrote a report this past Mon­day on high fre­quency trad­ing and impact on volatil­ity and cor­re­la­tions, and part of the rea­son why I wrote it — not that I nec­es­sar­ily have any greater insight into the impact of high fre­quency trad­ing on the mar­kets, but I was get­ting the ques­tion more and more.

I think peo­ple are very con­cerned about what they view to be a less level play­ing field, look­ing par­tic­u­larly recently at not just the intra­day swings, but the dra­matic rever­sals that we have seen in the last hour, which may be a func­tion of some of what I wrote about with the use of lever­age to exchange traded funds and the rebal­anc­ing that those have to go through through­out the day.

So it is some­thing I think, not just for our investors, but for indi­vid­ual investors in gen­eral, that has really plagued their psy­che is this kind of ram­pant volatil­ity that really says to a lot of them I am not even going to try to play the game, I am just going to get my per­cent in trea­suries and not worry about it.

PREWITT: Liz Ann Son­ders, senior man­ager of research in com­pet­i­tive analy­sis at Charles Schwab. More with Liz Ann com­ing up here in a few minutes.

8:10

(BREAK)

8:19

PREWITT: On the phone, we have Liz Ann Son­ders, the chief invest­ment strate­gist at Charles Schwab. We were talk­ing about retail­ers and Michael added the higher end — the Tiffany's and Ralph Lau­rens — are going to be doing bet­ter than the Wal-Marts and Dol­lar Gen­er­als. Is that pretty much your take as well?

SONDERS: Yes, I think if you look in rel­a­tive terms, there is no ques­tion that the upper end of the income spec­trum peo­ple are a lit­tle bit more flush. But chain store sales tend to cap­ture some of the lower end, too, and those are doing pretty decent, too. So this is not solely just a high end ver­sus low end. We are look­ing at I think bet­ter than expected upside across the spectrum.

MASSAR: Liz Ann, does that mean then you will be buy­ing some of the retail names, those higher end retail names?

SONDERS: Well, some of the dis­cre­tionary — the broad, I mean I am not the stock per­son at Schwab, but the — at the sec­tor level, con­sumer dis­cre­tionary, which includes almost all of those with the excep­tion of some of the dis­count retail­ers that will be in con­sumer sta­ples, we actu­ally have a neu­tral rat­ing on con­sumer dis­cre­tionary and actu­ally an under per­form on con­sumer staples.

So our out­per­form rat­ings are tech­nol­ogy and indus­tri­als, clearly have a cycli­cal bias to them, where our under per­forms have a defen­sive bias. And we tend to make our sec­tor rec­om­men­da­tions with a slightly shorter term per­spec­tive and it does reflect what we already talked about in the last seg­ment, which is our view that although the econ­omy is not boom­ing, a reces­sion will be avoided and I think the mar­ket is going to maybe pun­ish — at least in a rel­a­tive sense — defense in favor of more cycli­cally ori­ented earnings.

HOLLAND: Liz Ann, with that com­ment, we just had Marty Frid­son in a few min­utes ago talk­ing about junk bonds. He was refer­ring to the poten­tial for eight to ten per­cent kinds of returns from junk bonds over the next sev­eral years after default. Do you think com­mon stock will be com­pet­i­tive with that or exceed that?

SONDERS: Look, given a 12 per­cent rally in a nine trad­ing day, I would tell you that there are going to be prob­a­bly seg­ments in the mar­ket, seg­ments of time in the mar­ket where you prob­a­bly do quite a bit bet­ter than that. I think to try to esti­mate what longer term returns are going to be, your guess is as good as mine.

But my bias say for those neg­a­tive tail risks maybe com­ing out of Europe that I talked about, that I think could wreak havoc with the mar­kets in the short term, I think fun­da­men­tals of val­u­a­tion, cer­tainly sen­ti­ment do sup­port a mar­ket that will fair pretty well. And our bias has been within, from a tac­ti­cal per­spec­tive, yes, U.S. equi­ties over junk bonds.

HOLLAND: Inter­est­ing.

PREWITT: And U.S. equi­ties over emerg­ing mar­ket or Euro­pean or any­where else?

SONDERS: Yes, if we were to rank the three broad cat­e­gories with Europe being one of them, it would be U.S., emerg­ing mar­kets, and then non– U.S. devel­oped markets.

PREWITT: Why don't you like emerg­ing markets?

SONDERS: We do. We just like -

PREWITT: Like U.S. better.

SONDERS: We think the U.S. will con­tinue to out­per­form, which they have been. We think we are not quite through the con­cerns about some of the big­ger emerg­ing mar­kets, notably China.

That said, emerg­ing mar­kets have become much more rea­son­ably val­ued in light of their under per­for­mance. And we actu­ally think many emerg­ing mar­kets, includ­ing China, may be on the cusp of being able to start to loosen mon­e­tary pol­icy, which we think will actu­ally feed back into a bet­ter loop broadly for the economy.

I think that has been one of the hits to the global econ­omy is the devel­oped world has been loos­ing pol­icy, which has con­tributed to ris­ing com­mod­ity infla­tion, which hit the emerg­ing mar­kets, which caused them to have to tighten, which fed back into neg­a­tive growth, and so on and so on. But we may be able to break that neg­a­tive cycle with this infla­tion com­ing down, which may allow some of these emerg­ing economies to begin to ease. And that cer­tainly would be a more favor­able envi­ron­ment for their equity mar­kets. We are just not quite there yet.

HOLLAND: With that as a back­drop, Liz Ann, you have recently writ­ten about diver­si­fi­ca­tion. For the lis­ten­ers who look at things right now and see things — they seem to be mov­ing all in the same direc­tion at the same time in the same vol­ume and dimen­sion, what can you tell peo­ple? What can you advise them about diver­si­fi­ca­tion today as it relates to their anx­i­ety and angst?

SONDERS: Look, it's true. When you go into a period where mar­kets become very, very highly cor­re­lated, which they clearly have, hence the term risk on, risk off for describ­ing the envi­ron­ment, then most of the risk assets have seen cor­re­la­tions increase. And it gives you the sense that diver­si­fi­ca­tion no longer works, and maybe the sim­ple math tells you that that is the case.

That said, I don't think that that is a long lived phe­nom­e­non. I think it is a cri­sis dri­ven phe­nom­e­non that has caused these cor­re­la­tions to go up. So the assump­tion is they will go back down again and tra­di­tional diver­si­fi­ca­tion will work.

But the thing that does hap­pen when you get into a very highly cor­re­lated envi­ron­ment is you can find — you can expose mis­pric­ings because if every sin­gle asset class of maybe the risky vari­ety is mov­ing in tan­dem, we know for cer­tain that the fun­da­men­tals of those assets classes are also not mov­ing in tandem.

So it gives you an oppor­tu­nity to look inside, do your home­work, and fig­ure out where the mis­pric­ings are, what maybe has moved up that doesn't have the same jus­ti­fi­ca­tion from a fun­da­men­tal per­spec­tive, or down and actu­ally has much bet­ter fun­da­men­tals. So it gives you an oppor­tu­nity to maybe be a lit­tle bit more tac­ti­cal, look for those oppor­tu­ni­ties to estab­lish posi­tions in the port­fo­lio even in a high cor­re­lated world when things, cor­re­la­tions come down, you are now own­ing the right asset classes, the right secu­ri­ties, the right indus­tries, etc. So that is one ben­e­fit that comes from it.

And then also volatil­ity, ram­pant volatil­ity gives you more oppor­tu­nity to do what we know we are always sup­posed to do, which is peri­odic rebal­anc­ing, trim­ming back our out­per­form­ing secu­ri­ties, asset classes, indus­tries, sec­tors, what­ever it is. And we are now pro­vided more oppor­tu­nity to do that, and I think investors ought to take those opportunities.

PREWITT: Liz Ann Son­ders, the chief invest­ment strate­gist at Charles Schwab.

8:25

***END OF TRANSCRIPT***

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