First Trust ROI Podcast
On the ROI podcast, we discuss some of the most important questions facing investment professionals today, ranging from macroeconomic views, to perspectives on the equity and fixed income markets, to insights on practice management. We aim to cut through the noise, examine the data, and provide fresh insights to investment professionals as they help their clients find better ways to invest…seeking to generate attractive returns on their investments.
First Trust ROI Podcast
Ep 42 | Dave McGarel | Down but Not Out: New Opportunities Emerge as Equity Markets Broaden | ROI Podcast
Amid a sharp drawdown in US equities, Dave McGarel highlights the risks and opportunities that may lie on the horizon.
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Hi, welcome to this episode of the First Trust ROI podcast. I'm Ryan Isakainen, etf strategist at First Trust. Today I'm joined by Dave McGarrel, chief Investment Officer at First Trust. Dave and I are going to talk about what's going on in the stock market. This year. We've seen a bit of a softening in equity returns and we're going to unpack some of the reasons why we're going to talk about will the market broaden this year? And we're going to talk a little bit about what investors should consider doing in the midst of the sell-off and maybe the opportunities that might follow.
Ryan:Thanks for joining us on this episode. All right, dave, so we're recording this on March 20th. It's going to air on March 24th, so the viewers and listeners can kind of keep that in mind. Maybe extend you a little grace if there's a rally or if the market melts down on Friday. Hopefully we don't see that. But one of the things I really wanted to ask you about has to do a little bit with politics, but not really. From election day through inauguration day, the equity markets and risk assets really did well. They rallied, the S&P was up something like 4% and since inauguration day things have sold off. How do you explain that? Is that political or is there something else going on there?
Dave:Sure, that's the buy, the rumor, sell, the news, right, and that's kind of what the market did. Essentially, we're back to where we were November 4th 57.70, I believe that day on the S&P 500. President Trump wins, the market takes off. We hit 61.44, I believe, on February 19th 4.6% on our way to another 25% year, and then from that day, then maybe the last 19, 20 trading days, we've seen the market revert. Now, instead of being up 4.5% year to date, we're down 3% year to date as we sit here, and the market's exactly where it was pre-election and there's all kinds of excuses.
Dave:We got deep seek and AI. Maybe Microsoft doesn't need to spend 80 billion dollars every single year on capital expenditures and the rest of that. You know, hyperscaler cohorts, or maybe it's tariffs, or maybe it's inflation. Maybe it's tariffs or maybe it's inflation. Maybe it's the Fed saying, hey, we're not going to cut rates as fast as maybe the market would hope.
Dave:Geopolitical events not settled yet, even though there's been a lot of noise there. So there's all kinds of issues, but those issues materialize in the market when you start looking at how much you're paying for those risk assets. And essentially we had an expensive basket of stocks, especially if you look at the S&P market cap weighted when we started November, the day before the election, and we're right back to it, so it's still not inexpensive. There's not a valuation support underneath this market at these levels, but we're not at 61.44, which put us at about a 24 times multiple for this year's earnings if we have 10 or 11 percent earnings growth. So so the market just had gone up so much it needed to correct and we got a little bit of a correction here. We'll see if that's just a re-rating and saying, okay, we need to see some proof that we're going to make these earnings and things are going to actually materialize like the market expected when we started the year for that 10% earnings growth.
Ryan:So the S&P 500 equal weight relative to the market cap weighted version the traditional version of the S&P 500, the equal weight version has outperformed this year and that seems to be early evidence of some level of broadening for markets. Do you think that that continues throughout the year or is that something that we're gonna see the the mega caps rally again? Maybe I can guess your answer based on what you're saying about valuations. But what do you think?
Dave:yeah, I think it's a multi-year story.
Dave:Okay, we had 70% of the S&P 500 return in 2023 come from the MAG 7. Last year it was over 50% came from the MAG 7. Think about it there's 500 stocks in seven companies in consecutive years where we returned 26% on the S&P 500, with dividends in 2023, 25% in 2024, and half of that return more than half of that return, more than half their turn just came from seven companies and those seven companies didn't see their earnings grow anywhere near as fast as their stock prices. So we've added a lot of multiple at the very tippy top of the SP 500. A ton of weight in that top basket of stocks at the SP 500, maybe 36%, sitting in just 10 names at the top of a massive $52 trillion index. But they traded 29 or 30 times earnings. So it's historically incredibly expensive and maybe a harbinger of looking backwards instead of looking forwards at where the future growth is coming from, because when you do look at earnings growth going forward, it's much more spread out than it's been the last couple of years.
Ryan:So a lot of people will cite the uncertainty that's crept into the market. Some of it related to what the Fed is going to do with interest rates, some of it to do with other government policies, especially tariffs. I wanna talk a little bit about tariffs and their impact on stocks, because I think that is what is on the mind of a lot of investors. I guess my question for you, then, is do you have any thoughts on what's happening with some of the tariff policies, and will they ultimately impact corporate profits and stock prices?
Dave:Sure, absolutely. I mean, tariffs across the board are unhelpful to faster growth and unhelpful to lower prices for consumers. It's that simple. You have less choices. If we put a 200% tax on champagne from France, nobody's going to buy French champagne here, so that doesn't, and the cost of champagne from somewhere else is going to be more expensive for consumers here because there's going to be less competition, right? So it's pretty simple at the end of the day.
Dave:Again, I think the markets generally has perceived that most of any tariffs that are out there will be short-lived and mostly a negotiated tool. Perhaps the market got a little doubtful of that over the last couple of months, but but I'm not sure tariffs is the underlying root cause here. We just have a very expensive stock market and you need to look for value other than this place where we've seen the performance come in the last couple of years, and that's really, I think, what's changing things. You had companies at the very top, the best companies in the world, kind of hitting their head on the ceiling. All of a sudden, you got to spend a lot of money on AI, infrastructure, asset-heavy businesses for businesses that we love, that we asset-light whether that's Microsoft or some of the other big names, the hyperscalers and Google and Meta. And all of a sudden they're saying we have to spend a ton of money on capital expenditures.
Dave:And investors are saying wait, I loved your business because you're not building new factories. And now you're building new factories and you're taking all of your profits in building new factories and you're not telling us that it's not gonna be a continuum. Year after year after year with this build out and we don't have enough proof yet that AI is going to actually goose your earnings much faster than the forecasts sit today.
Dave:So, that's some of the consternation that's sitting out there. I think of broader than just the tariff story. I think it's a whole conundrum of factors that concern investors today, and stocks were just too expensive with all this uncertainty out there. And stocks were just too expensive with all this uncertainty out there.
Ryan:So, dave, to your point, when you look at sectors of the S&P 500, I looked a couple days ago and eight out of the 11 sectors actually had positive returns this year and the ones that didn't were those sectors involving the companies that you're mentioning. That are technology companies or tech plus companies that are spending all this money like they're an industrial firm or an energy company or something like that. So I think that's really interesting, because you haven't historically thought of technology companies as being heavy spenders making big capital expenditures. Do you think that that will continue going forward, or are they going to have to get capital discipline, like we've talked about with the energy sector, at some point?
Dave:Sure, at some point you can't. Microsoft, I think, made $85 billion last year. They say they're going to spend $80 billion on capital expenditures. Well, just two or three years ago they spent about $25 billion, $28 billion, and slowly they were already spending 11%, 12%, 13% of their revenue on capital expenditures and this past year or this year they're expected to spend closer to 22 or 23% of their capital expenditures to sales. So a massive increase. And there's no different at Meta, it's no different at Google, it's no different at Amazon.
Dave:And you start looking at the cash flow the best cash flow companies in the world, don't get me wrong. But all of a sudden there's all these other needs for cash where investors are just saying we can just buy back stock, you can reward me with dividend increases, whatever it might be, that's great. Or you can make an acquisition, like Microsoft bought LinkedIn and all kinds of uses to grow. And now you're telling me it's gonna be really capital intensive. Well, when you have capital intensive businesses, those assets depreciate and need to be replaced. So nobody knows the chips that are going to come in 27, 28, 29. Are we talking about just recycling and having this 20% plus capital expenditure to revenue ratio for the rest of this decade, and that is giving just some consternation to shareholders about where do I get the returns that I expected? And that's where the uncertainty comes in in that trade, in our view at least, when we look at all this data.
Ryan:Yeah, I hadn't really thought about the depreciation of some of those assets. And especially when you're dealing with technology and these really advanced chips and you hear N hear Nvidia talking about their new generation of chips and you just wonder how quickly, if those chips get much better and continue to get much better, you're gonna have to replace them and that's a whole, you could have a pretty fast depreciation of those existing assets if that's the case.
Dave:Exactly and if you need to replace them, unless these costs really come down, it's gonna be a continued big investment that didn't exist just a couple years ago for those companies.
Ryan:So I think a lot of the focus at least the narrative focus this year has been as risk assets have begun to sell off and people have gotten a little bit anxious and nervous. The narrative has been focused on some of those things like tariffs, whether they're the cause of the sell off or not, but it doesn't seem like there's been as much focus on some of the things that could be coming down the road, like extending the tax cuts or maybe extending the tax cuts or potential benefits of deregulation or those sorts of things. Do you think investors are paying too much attention to some of the near-term kind of uncertainty, and when will they start to give more credit to some of the more optimistic things that could be coming down the road?
Dave:Again. I think a lot of that has been baked into stock prices. Now we have come off the highs but again at the S&P 500, you're close. Let's do it this way. We're at 5,700 today. Earnings forecast are for $261 this year. May that hold. That'd be about 11% growth from last year's 235. But next year's forecast is for $300. That's another 12% or 13% growth. Those are above-average earnings. That's another 12 or 13 percent growth. Those are above average earnings In a period of time.
Dave:We're not forecasting above average GDP growth here and yet we have this forecast. So maybe companies will be productive that say they make the $300. Well, $5,700 today divided by $300 is 19 times the 25-year multiple on the S&P 500, looking forward is 17 times. So if we may have two great years of earnings growth and stocks don't go up from here at all, stay flat, you would have a multiple of 19 times at the end of 2026. So if you look at the market cap weighted index, there's no way to say, hey, we have some valuation support here. But the top heaviness of this is the reason that we're seeing this broadening out, because there is valuation support once you get through stocks 200 through 500 in the S&P 500. Much cheaper basket of stocks than the 29 or 30 times you're paying for the top third of the market, versus 17 times when you get to the bottom 300 companies that make up a very small percentage of the S&P 500 weight.
Ryan:So for those podcast viewers who haven't seen the Market Minute with McGarrel, it's something that you publish once a month. It's a short, one-page kind of snapshot of what your views are on opportunities in the market. And so this year you've been talking a lot about momentum and quality and those are kind of the best factors over the last couple of years, and you said something like you know, three-peats are rare when it comes to factors. So when you look at all the different factors that you know our research team uses to build portfolios, where do you see opportunities?
Dave:Sure, when you think about 2023, quality was the best factor. The reason is because in 2022, when the market got routed down 18 percent, growth stocks down 30 percent a lot of good quality growth stocks fell hard that year we got. The worst factor in 2022 was quality. The best factor in 23 was this rebound Things were better than expected, higher rates didn't hurt the market and its earnings growth significantly and we saw quality rebound and be the best factor. Then last year, quality was the second best factor. And so you look this year and then you look back at a jelly bean chart to say let me see all these factors low volume value and a smaller size in momentum and you look at those factors and you do not see any three-peats Nobody. Three years in a row, like 98, 99, momentum was the best factor. Everybody was invested in momentum and how did momentum do in 2001? The worst factor both years. So it's very difficult to three-peat. You know the joke is ask Patrick Mahomes, right, ask the Kansas City Chiefs. It is not an easy feat. And the deal with quality is because at the end of 2022, the quality factor is because at the end of 2022, the quality factor, which typically trades at a slight premium to the S&P 500, actually fell to a 12% discount. Quality the easiest thing to purchase a quality basket of stocks was at its biggest discount since 2000 on the chart that we have, and even earlier than that I had never seen a 12% discount on quality stocks. And so what did we do? We took those quality stocks, we drove them to a premium of 9% on February 19th and now we're back to about a 4% premium. So quality isn't on sale. It's not as expensive as it was just a few weeks ago. You can buy a quality basket of stocks, but you don't want the concentration risk in some of the names that are very expensive and still qualify as quality stocks. We're going to see different factors value, perhaps, maybe low volatility. Although they work as a bond proxy, we don't really need a bond proxy today where rates are. But you've seen healthcare, you've seen staples, financials at the top.
Dave:I think if we avoid a recession here, even if we slow growth down, that you're going to see the cyclical sectors hold up financials and industrials. They have a lot of avenues for growth with the AI build-out on the industrial side. Financials one of the crown jewels of our economy are our big banks and our insurance companies. Those are USA crown jewels. They have massive amounts of capital, they have phenomenal businesses worldwide and they're just dominant companies and they have a bunch of different avenues for growth. If you're the big banks, you have investment banking. It's slow because of the uncertainty, but at the same time, think about the volatility of the last 20 trading days and what that does for all the trading desks at a JP Morgan, a Morgan Stanley, goldman Sachs. They're going to have a phenomenal quarter when it comes to that and invariably, every time something isn't working say mortgage underwriting, something else is working for those banks and when everything comes together, that's when they make just a massive amount of money.
Ryan:So you like the cyclicals, the financials, the industrials. When you think about what the Fed is doing and where we are with interest rate policy, what impact will that have on stocks, whether it's the sectors that you mentioned or just overall? Do you think that rates are about where they're going to stay? Are we going to be in kind of a higher for longer environment, and what are some of the implications?
Dave:Sure, I certainly think higher for longer. We're not going to see zero, hopefully anytime soon. I think in a very long time, if ever we're going to see that zero interest rate policy. The market maybe three, four, five months ago was thinking the Fed had cut two or three times. I think right here, with the next move still viewed by the market as lower than today is what's most critical.
Dave:If the Fed indicates in any way, shape or form and the market gets in it, the Fed might have to raise rates, mostly because of inflation, and in our view the market's gonna get creeped. Okay, that is not beneficial to housing, which is a huge part of the economy. It's not better for individuals to go out and get debt to purchase cars or any other durable goods, and higher interest rates, or the threat of higher interest rates will take this market down significantly. On the other side of things, if things do get weak and even if we don't go into a recession and we see GDP growth slow and the economy struggle a little bit, the beauty of where the Fed is today is if inflation is under control, not getting worse, coming down, the Fed's got 450 basis points at their disposal so they could cut 25 basis points, signal that they'll cut if they see continued weakness and that will spoil the market and give the market an opportunity to go higher here.
Dave:I don't think we're going to see a 20% market. If we ended this year and we were close to 6,000 from 5,700 today and you get your 1.5% dividend rate or whatever in the S&P 500, I think that would be a pretty good year after two fantastic years in the equity markets. And if rates are still expected to stay here or go lower, I don't think that'll be an impediment to the market going a little bit higher from here.
Ryan:Yeah, it's interesting because it doesn't seem to me that businesses are going to really change the way that they do anything if they expect rates to drop 25 basis points, 50 basis points by the end of the year or something like that. That doesn't seem like it would influence the economy or decision making in any real way.
Dave:Yeah, I'd agree. I don't believe there's. We have massive profitability in the S&P 500 today. Better profitability if we miss earnings and don't do 261 this year, we'll do 250. It'll be the best earnings in the S&P 500 history and it will be about 60% or 70% higher than 2019, which had been the best year before four consecutive years of putting over $200 in earnings in the S&P 500. So it's pretty amazing the profitability. Maybe there's some relation to COVID and what companies learned then at the expense level.
Dave:Maybe it's fiscal monetary to COVID and what companies learned then at the expense level. Maybe it's fiscal monetary stimulus and it's sticking around for a really long time. That's probably some of it. But we've seen massive earnings and companies just have the wherewithal to do a lot with those earnings if we hit anywhere close to the expected number this year. So we've got a really good set of companies and a really significant earnings profile out there and if we see earnings keep going up, you know stocks can actually, you know, make slight gains this year, even where the valuation is.
Ryan:So Westbury talks about the embers of inflation and you know the possibility that inflation does kind of roar back to life and you mentioned that if the market perceives that the Fed is going to have to raise rates, that we could have some level of sell-off. Where is the tipping point, I guess, in your view? What level of inflation is the Fed really going to sit up and pay attention like, oh boy, we better shift our stance, because it seems to me that they would be very hesitant to want to change any stance at this point.
Dave:Oh, absolutely. It would have to be data-driven and they would have to see an uptick in inflation. It's as simple as that. It would have to start going. I think if it plateaus or sits here and just moves around a tiny bit right around where it is today, in the 2, 2.8, wherever it is, they'll assume that with rates where they are, with some of that stimulus still coming off, that we'll see a continued decline, even if it takes a lot longer than they might have hoped. But if we get some prints that start seeing higher numbers and they might say it's temporary again. But they're gonna be very, very cautious there when it comes to lowering rates from here. But also to your point, man, do they not want to raise rates? It means they cut them too much. It's that simple.
Ryan:The other thing that I've noticed this year and maybe it goes hand in hand with the broadening trade or the broadening market is that the international equity markets have done better, and some of that might have to do with movements in currency or something like that. But how do you look at international stocks this year? Is that an opportunity? They are historically cheap, but maybe that's because of some level of risk. How do you look at international stocks?
Dave:Sure, you could see that Europe is having a great year so far in the first two and a half months I don't know depending on which market somewhere between 8 and 14 or 15 percent. Is it because they're going to grow faster in Europe than the US? No, we're still expected to go GDP growth generally below 1 percent. But you know, their banking system has been atrocious and maybe that catalyst for why Europe is doing better in some regard in that sector is the Credit Suisse acquisition by UBS. And, all of a sudden, if you look at a basket of European stocks, they've been fantastic over the last year. They've outperformed the MAG7 over the last year.
Dave:European financials, and they have some really good financial companies that finally, 15 years after the 08-09 crisis, have gotten their balance sheets in order, their capital in order, and there's this little bit of a groundswell that you can see and that's with those financials saying we can compete with some of those big American banks.
Dave:And it's the energy companies saying we've been left behind with moving into, you know, green energy too quickly. We always kind of knew that fossil fuels were going to be around for a long time, but we took our foot off the gas and now Shell and BP. They're talking about putting their foot back on the gas and realize this is a long transition. So they're getting the message from their shareholders that the reason our stocks are doing so poorly is because your earnings growth is not good, getting the message from their shareholders that the reason our stocks are doing so poorly is because your earnings growth is not good. And the way you get earnings growth is give the consumer what they want, and right now it's still fossil fuels. The banks have recovered, so Europe is not in a better position than the US. However, to your point, usually we enjoy a 15 to 20 percent premium to European equities, international equities in the US. American exceptionalism, better margins, better regulations, typically.
Ryan:Different mix of industries as well, Of course yeah, we have a much wider spread.
Dave:We have the technology footprint. We deserve that premium, but it had gotten outlandish. It was absurd how cheap the rest of the world is versus the US and I always kind of take a step back and realize we hit way above our weight.
Dave:We got 4% of the world's population, 24% of the world's GDP, but 76% is somewhere else and they're trying to improve their lives every day and grow their net worth and better lives for themselves. And I think, at these prices, investors just woke up and said if we're going to get a market that's not just led by seven stocks, it's going to be broader, it's going to be small, mid value growth and even international at this point where there's some pretty good opportunities.
Ryan:Germany just made an announcement that they were going to increase spending quite a bit. I think they have something like a 500 billion euro or dollar I'm not sure which spending package where they're going to increase spending on defense and on infrastructure and on some other things. Do you think and I've noticed that you know the German equity market has done fairly well as that announcement has come out, but do you think that that has some level of I don't know stimulus that will maybe help some of the equities related to that?
Dave:I do. I think it is Europe waking up and saying how do we compete? And the way we compete is to invest. You know they're actually cutting rates over there. The ECB's cut, I think, a couple of times this year in the last six months or so and we've been stagnant on our interest rates at the Fed level. So there's some I think everybody's too scared because of all the false alarms over the last five to 10 years of oh, there's little green shoots coming up in Europe and they never materialize and maybe, knowing that our administration is going to deregulate, they're going to be pro-growth. Now, whether it works or not, that's their intent and Europe is gonna get left further behind if they don't have some of that approach going forward. And I think you've seen kind of the new US administration spurring the rest of the world saying to compete, we're going to have to actually step up our game and I think that's what the market saw, has seen, with this double-digit rise in European equities in the first two and a half months of the year.
Ryan:Yeah, it seems to me that most investors that have allocated to international stocks, unless they're rebalancing on a consistent basis and I suspect that those that are using a financial professional to help them manage their money, yes, they're maybe rebalancing, but there's a lot of people that don't rebalance and I think there's a lot that are underweight, probably international stocks. They're probably underweight a lot of things apart from US growth, and so that seems like would be a source of funds to maybe buy some of these areas that we've been talking about.
Dave:Yeah, it really speaks to diversification right Again. This year, you know, in the first two months, health care is the number one sector. After the prior two years it was right at the bottom. Energy is near the top. It was lousy the last couple of years. Consumer staples are doing fine this year. Financials are doing pretty well the first couple of months of the year, and so diversification is perhaps boring to too many investors who've just seen this rise in tech or tech-related names and generating returns on an Nvidia that goes from $500 billion to $3 trillion.
Ryan:That's not normal.
Dave:Normal is a much lower rate of return than what we enjoyed in 23 and 24.
Dave:And risk positioning is going to become more prevalent in portfolios. There's a lot of portfolios. When you do an x-ray, a lot of investors would say, wow, I can't believe I have a beta of 1.2. That was never my intent, but what's happened in the markets is everything skews towards the top. Remember, if there's 36% and 10 names at the top of the S&P 500, there's only 100%. So if we put more at the top, where's it coming from From all the other companies that are towards the bottom of that S&P 500. So companies that might have had a 10 or 12 basis point weight in the S&P 500 10 years ago might only have a 5 or 6 basis point weight, even if their stock's done fine. We just put so much multiple and so much weight at the top of the index. It doesn't mean those aren't still really good opportunities.
Ryan:Well, dave, I'm looking at the clock and time once again, has flown by. My final question for you is kind of a retrospective philosophical question for Dave McGarrel, as you manage a big department of research at First Trust, as you're talking to younger analysts and portfolio managers just coming up, what's the most important piece of advice that you would give them?
Dave:Sure, I'll talk to old people who've experienced a market that is different than, I would say, the last 15 years. Covid was a hiccup. 08-09 was devastating, and so I mean 08-09 was as tough as you can experience. 98-99 was just a valuation story. That's certainly caused bear markets and people lose a lot of money, but 08-09 and the power of leverage was in full view at that point in time and marks on assets liquidity were big issues. We have not seen any events like this. Liquidity were big issues. We have not seen any events like this.
Dave:I'm not asking for one, but everything is easy when the market's going up like it's been going the last couple of years, when there's that much liquidity, when anybody can raise capital regardless of what the asset looks like, when people are willing to take risk even if it might not be a great risk-reward scenario and we've seen all of that and I think we're just in for a different market. And compound interest over time. That's how you make a lot of money. Timing the market seems really easy, and when it goes the other way, when you break stride, it's really hard to win the race. We broke stride here the last 20 trading days.
Dave:I think we're in for a different market Doesn't mean we need to get creamed.
Dave:Earnings got to hold up for the market to make small gains. But the way you make, how perform in a market that gives you small gains, is getting diversified and owning, at points in time, international stocks or small cap value stocks when they hadn't done anything for a long time and you get it really concentrated in a brief period of time. And if you don't have any of that, if you're way underweight, then you have to make a decision. Do I chase that? Is it real? And that's a really hard decision to make. It's much easier, thinking about where we sit today, thinking about the rest of this decade, to say, if we get 8% per year on average through the end of 2029, 2030, that'd be a great return for equities from where we start, especially if we just look at the SP 500, to outperform that. You can use some other tools today to de-risk your portfolio from the concentration in the S&P 500, but also to outperform that index if we don't see the same exact story we've seen, which we don't expect to see, in 2023 and 2024.
Ryan:All right, Dave, thank you for that perspective Overcoming recency bias is how I would encapsulate a lot of your comments there.
Dave:But, as always, thank you for that perspective Overcoming recency bias is how I would encapsulate a lot of your comments there. There you go, sure.
Ryan:But, as always, thank you for joining us on the podcast. We'll look forward to having you on at some point later this year, hopefully. But again, thank you for joining us and for your insights. And thanks to all of you for joining us for this episode of the First Trust ROI Podcast. We'll see you next time.
