What May Cause Volatility's 'Next Leg': Liz Ann Sonders

What You Need to Know

The Rule of 20 suggests the S&P 500 is overvalued based on historical trends, Sonders tweeted.
Schwab suggests investors lean into quality and fade low-quality areas that have been rallying.
Rally leadership may be sending a less optimistic economic message, Sonders suggested.

The stock market rally from June lows may not contain as upbeat a message about the economy as it seems, according to Liz Ann Sonders, chief investment strategist at Charles Schwab & Co., who said Thursday she sees “a little bit of froth in the market” concentrated in non-traditional areas.

Sonders, appearing on the TD Ameritrade Network, also suggested that if employment weakness develops, or earnings deteriorate, the markets could experience a new round of choppiness. These conditions may lead to “the next leg of volatility for the market before we can start to think about the next economic upcycle, which is when you want to go down the quality spectrum,” she said

Separately, Sonders tweeted Thursday that the so-called Rule of 20 suggests the S&P 500 today “remains overvalued relative to history.”

The longtime formula assumes the market is fairly valued when the price-to-earnings ratio plus the inflation rate equal 20. Sonders’ tweet included a Bloomberg chart showing the S&P 500 index plus the consumer price index recently north of 25.

Inflation’s Impact

Inflation is a key denominator in knowing the market’s fair value, she told the TD Ameritrade Network. If inflation gets under control, that would support higher valuations; if the economy’s not out of the woods yet with inflation, there’s probably more downside to valuations in aggregate, she said.

While the stock market may anticipate a Federal Reserve pivot to cutting rather than raising the benchmark interest rate, Sonders suggested that the central bank likely won’t do so in the near future, given high inflation, unless the economy deteriorates significantly.

Inflation has taken a step in the right direction, inching down to 8.5% from 9.1%, but that ‘s far from the 2% inflation rate the Fed has targeted, Sonders noted. She doesn’t expect the central bank to pivot unless the economic or labor markets deteriorate more than the levels currently baked into the pivot narrative, although the Fed might take a pause to the extent that inflation heads lower.

“I’m not sure I understand the pure economic optimism associated with a pivot to rate cuts. Rate cuts probably only come because of the economy being in much worse shape than it is right now,” she said.

Utilities have led the S&P 500 index rally since the June low, followed by consumer staples, Sonders noted. “I’m not sure that that is an overly optimistic economic message,” Sonders explained.

The market rebound from June showed much healthier overall breadth than previous rallies, she said, referring to the measure of how many stocks took part in the move. Schwab’s breadth studies suggest “we could continue to see some choppiness in the near term” but that returns should be very good in the next 12 months, according to Sonders.

The recent rally, however, included a heavy degree of short selling and significant moves in areas “down the quality spectrum,” such as meme stocks and high-volatility, no-profit market segments, she explained.