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 30 | Dave McGarel |Broadening Markets and Factor Investing: Opportunities Amid Fed Rate Cuts | ROI Podcast
Dave McGarel provides insights on what sort of stocks are poised for long-term outperformance in light of Fed rate cuts, valuation gaps, and factor analysis.
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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 equity market, when the market will broaden out, or will it continue to broaden out, and where there might be opportunities, especially from viewed through a factor lens. Thanks for joining us on this episode of the First Trust ROI Podcast. All right, Dave. Well, thank you for joining us on the podcast. Again. We are recording this on the first day of the Fed two-day meeting before they announce what the results of their policy will be. So it's kind of unfair, but I think it's pretty safe to assume that they're going to cut and I'm not going to ask you if it's going to be 25 or 50, because you'll be proven right or wrong and it's kind of a coin flip at this point. But what I will ask you is how important is it that the Fed is likely tomorrow to have begun cutting rates?
Dave:Yeah, I think that's the right way to frame it, ryan, and a good day to you. The rate cutting cycle is what's important. $25 or $50 tomorrow, september 18th won't be forgotten. In a week It'll really be about the rhetoric and the Fed speak of. Where are we going? The market currently believes we're going to have 200 basis points of rate cuts as early as July. Maybe another 100 basis points of cuts by the end of next year and that would put us at a Fed funds rate closer to two.5, 275 from 5.5 today. And if inflation stays benign and actually declines a little bit more, the market, I think, believes that's where we'll wind up and that certainly helped the economy immediately. But if the market does believe that that is the path and it is uninterrupted probably unlikely then I think that will be a significant positive for Stenox.
Ryan:Do you think we pay too much attention and talk about the questions of whether it's 25 or 50 and pay more attention to these things than we need to, then Completely If it's 25 or 50, we're going to five and a quarter or five.
Dave:I don't think it'll change anybody's behavior, certainly overnight. Eventually it'll change the behavior of companies and investors. When you can't get a risk-free rate of five and a half and when you are a company and your cost of funds goes significantly lower, even ahead of all of those potential rate cuts, you'll see both consumers and companies start responding with either capital expenditures or different aspects in the housing markets at the consumer level, indicating that now is the time to be able to go ahead and make some of those purchases you might be holding off on when you had mortgage rates north of 6% and close to 7% the last 12 to 18 months.
Ryan:So one of the byproducts of the front end of the yield curve moving lower is that the yield curve has now gotten to a point where it's normalized. It's no longer inverted and in the past often we've seen recessions follow. After a long inversion, the yield curve normalizes and there is often a recession. Do you think that that is likely to happen in this environment, or is there something different about this time?
Dave:I don't know Well. I mean, there's lots of things different about this time. The Fed had a massive rate hiking cycle that we expected remember that one to be pretty linear 25 base points a time over a long period of time, and somehow the Fed raised 350 basis points from May of 22 through December of 22, with 475 base point hikes in there, which nobody had in the forecast. So the forecast currently the Fed just slowly lowering rates and that's avoiding a recession, I think is the path forecast. Will we have a recession? I don't know that the yield curve is. You know, if you have a thousand iterations of something and 90% of the time it happens, but when you have eight to 10 recessions and you see something, it's really hard to say that's causation instead of just some level of correlation.
Ryan:Yeah, I've always thought that too. It's a small sample size.
Dave:Yeah, we need more, in my view, than just the bond market indicating and telling us that we're going to have a recession, and a few times more than not it actually happening. So I don't look at that as the biggest signal. I think it'll be much more about what we see in the unemployment arena, what we see in the GDP growth arena, what we see in the GDP growth and what we see in companies and capital expenditures, if they do ramp up here with the forecast for lower rates.
Ryan:As the Fed begins a rate-cutting cycle, that'll have some impact on the longer end of the yield curve, but it won't be point for point. Do you think that the 10-year say and that part of the yield curve, we're going to see a sort of dramatic reduction in rates, or is that already being priced in today?
Dave:I think a lot of it's been priced in. I think in the two-year we lost maybe 100 base points in the last couple of months here, once it was obvious that the Fed was going to cut with, I believe, that July unemployment report, and so I think the market adjusts really quickly when the thesis changes, and I think you've already seen that. Certainly, I think the expectation is that we'll see the curve steepen as we move throughout this year and with the short end coming lower. But the market, I think, is always very far ahead of that and I think they are at this time as well.
Ryan:It seems like that's a good thing for the economy because if it wasn't beginning to be priced in, it seems like people would make decisions. You mentioned capital spending and all these other decisions waiting for rates to come down because you want to finance whatever your expenditure is M&A or something at a lower rate. But if it's already baked in, then maybe decisions won't be put off as much.
Dave:Yeah, I would agree. I think if we have eight rate cuts expected 200 basis points as early as July, that's nine months you put your capital expenditures in place well ahead of actually making all the expenditures.
Dave:So I think it'll start being reflected in a lot of budgets and I think, if you look at last year, a lot of IT budgets were cut. Obviously there's a massive spend with the hyperscalers in the AI space, but when you look across the average company and its IT spend, it's been very flat over the last year or so in the software space and service space and I would expect to see that increase, since obviously technology is a massive spend across the entire S&P 500, all 11 sectors, and I think those budgets will increase with the expectation rates are going to be lower.
Ryan:So one of the themes that we've talked about a lot in the last couple of years is the expectation that eventually the stock market's going to broaden. It's been very narrow for an extended period of time, favoring those big mega cap technology and tech plus names, but getting the timing right on the broadening is kind of a challenge. Do you think that we've begun, as the Fed has indicated they're going to pivot and as rates in the 10-year have begun to trend lower, we've seen some broadening over the last couple of months. Do you think that is going to continue and maybe stay put this time?
Dave:I do. It's actually probably lost on a lot of investors if you're not looking every single day at the best sector. This year through today is actually not technology. Technology is in second place and utilities is the best sector. Now some might say, well, that's just an AI playing a thirst for energy because of AI.
Dave:Perhaps, some of them may be that dividend trade investors getting ahead of that if the Fed does cut rates to 100 basis points and we start talking about bond proxies in the equity markets again. But if you look at the fourth best sector, it's up 20%. That's financials, and on top of that you have consumer staples, defensive and dividend paying sector as well, and those are all right around 20% gains. And most interestingly, if you take tech, which is still up 25% of the year, but realize that NVIDIA is up 130% year toto-date and it's 10% of the tech sector, that means tech apps in NVIDIA is actually only up 12% or 13%, which would put it in eighth or ninth place when we look at all the S&P 500 sectors, without one stock. So why is tech underperforming? Financials, utilities, consumer staples and so many industrials and all these other sectors? If you take NVIDIA, the rock star of the stock market and the best stock in the stock market this year, no stock is up better than NVIDIA and that is, to me, the market running out.
Dave:The problem for investors who are trying to time everything is we haven't had any rate cuts and yet the market has already broadened. When you say financials are up 20%, that's not a big growth sector. When you say industrials are up close to that and staples, the defensive sector, are up around 20%, those are double average annual returns and it's only eight and a half months into the year without any rate cuts. It's a little bit of buy the rumor, sell the news maybe, but when we start looking at valuations and profit forecasts I think there's still more broadening to go, because it's been such a lopsided trade for so long.
Ryan:So those areas that you just mentioned, some of the defensive areas like utilities and staples financials, are valuations for those sectors still relatively attractive compared to something like information technology, sure, and I think the real story there is.
Dave:Not only are valuations significantly more attractive, there's still a huge dispersion between growth and value stocks, but the earnings forecasts are what will drive a further broadening. So if you can get similar earnings or close to similar earnings in sectors that are priced 50% of where some of the glamour sectors are at a significant discount, that's not really reflecting the earnings forecast at this point. It's reflecting past performance and kind of the old phrase skating to the puck where it's going. That's what's been happening. Utilities are up 26% 27% this year because people thought utilities got too cheap. Or financials at 11 or 12 times earnings earnings. That's just such a good bargain. No, it's looking at the potential for these companies to start distributing bigger dividends, buying back more stock, because earnings profiles look a lot better in a lot of those areas one of the things that we pay attention to with some of our product development the products that we offer at First Trust are factors.
Ryan:It's something we talk about a lot. You've mentioned a little bit about, maybe, demand for dividend paying stocks a moment ago. You mentioned as utilities have often been a place where you get dividends. Is that your favorite factor right now dividends, and are there any others that people should be paying attention to?
Dave:Sure, I think it's clearly been a momentum market. Even as we sit here today, even as the market has brought out, momentum still been a dominant factor. There's a decent amount of speculation when you have the kind of momentum we've had this year as well. But when you start looking low, vol is now neck and neck, because of that volatility in consumer staples trade with the momentum factor as far as forecasting some year-to-date performance. But if you think about the Fed and a bunch of rate cuts on the way, what are the beneficiaries?
Dave:Well, from a stock market standpoint, an investor standpoint, it would be dividend-paying companies, because I need to replace that risk-free income from T-bills or T-notes or short-duration risk-free funds with something that can give me some comparable income. And frankly, in the equity space, with qualifying dividend income, you can get better tax consequences with dividend-paying stocks in many cases than you can in some of the fixed income spots, some of the fixed income vehicles that are available today. Size so small cap stocks have a higher cost of capital. It's harder to get capital for those companies and they also typically have a lot more floating rate debt on their balance sheets. So if rates do fall 200 basis points, one of the biggest beneficiaries will be small caps.
Dave:Finally value stocks Value stocks are traded at much lower multiples of a price to book or price to sales, and they also carry a lot more debt than a lot of growth companies. They don't have those same kind of quality balance sheets. Well, if you don't have the best quality balance sheets, that means you must have a lot of debt on there, and lower rates should help that trade as well. So it's been again such a lopsided trade for so long. I would implore investors not to think they've missed anything, even with a little bit of a re-rating here. In the size factor it's been very good since last October, pretty commensurate with large cap, mid cap stocks as well. So that size factor is evened up. But again, it's not linear.
Dave:It comes in like big chunks and then sits there and you say, eh, maybe that's done. But when you look at the valuation gap between small and large, I think there's still a lot of opportunity there.
Dave:It hasn't happened in the value space really very much. It's been the higher quality if you want to talk about value names, the biggest names up there in the S&P 500. But if some junkier balance sheet companies that still have good companies, good businesses but just don't have the same quality balance sheets, if that gets a move you could see a significant re-rating there and I could see multiple expansion in that space. Arguably, more than any other factor out there would be something in that value factor space.
Ryan:It's always interesting because we're all subject to behavioral biases, and this recency bias, where we want to chase what did well most recently, I think, is a battle that all financial professionals have as they're trying to guide their clients, and value is one of those areas that you hear more and more that you know this doesn't work anymore. These stocks are cheap for a reason. They're going to stay cheap, but that doesn't seem to be your outlook.
Dave:You know we have obviously a lot of interest across the board in the retail community, in the stock market and some of it's silly the meme stocks and some of the initial coin offerings and things that are just incredibly speculative. But there's also this fascination with the best companies in the world, and rightfully so. They garner all the news and suck with the best companies in the world, and rightfully so. They garner all the news and suck all the oxygen out of the market.
Dave:But at the end of the day the stock market only responded to cash flows and earnings, and it doesn't really care what the ticker symbols are and how big the company is. At the end of the day, it looks at where is their earnings power? How much am I paying for that earnings? Can I forecast it with any precision? And then they forget about exactly what the company might actually be doing to earn all that income.
Dave:As long as they are comfortable with all that fundamental picture and right now we're still in a market that is clearly fascinated with the potential and the forecast for things into the future that are very unknown, and that AI spend is dramatic and that's where retail investors continually go. But they're also the best companies in the world, so that's where the portfolio managers go as well. But there's going to become a point in time where a portfolio manager starts to realize the best returns are to be had somewhere else, and that's how you beat that index, that top heavy index, and I think we're getting closer and closer to that, and there's all kinds of data to support that If you really look underneath the surface instead of look at the headlines and say what's the story about NVIDIA or Microsoft or Apple today?
Ryan:So you mentioned re-rating the valuations of some of those value stocks, some of those smaller stocks that are relatively cheap. Does that happen at the other end as well? Do you think where you've got some of these expensive stocks and maybe they don't have room to expand their multiples, but do you think those multiples are likely to fade, especially as you mentioned some of the fund managers and others?
Dave:start thinking about rebalancing out of those stocks.
Dave:Absolutely, I think there's the potential for that.
Dave:It's certainly hard to find ways for a lot of those companies to expand their multiples and then when you look at their earnings growth, in most cases and NVIDIA is the wild card and you don't really know it, but their comparisons are getting more and more difficult every single quarter after an unbelievable earnings surge the last six or seven quarters, it gets really hard to figure if we're not going to see faster earnings growth than the rest of the market, significantly faster.
Dave:We're already paying a very large premium for a lot of those companies. Why would we start to pay significantly more for those companies in the absence of something new happening which would dictate that earnings are going to go much faster from a much larger base when you start looking at those companies, those FANG type of companies at the very top of the market? So I think that's potential to see at least stop that multiple expansion from increasing any further multiple expansion in that continuum of stocks and then narrowing the gap, whether it's value or size or dividend yield, in that valuation gap between that basket Again it's really narrow at the top.
Dave:I mean we know that 10 stocks are 36% of the S&P 500. That's almost a $50 trillion market and a third of it is in 10 companies and they're priced in the high 20, multiple, 28, 29 times in a market that's priced closer to 22. And the earnings growth forecast. It's much more spread out than saying that 30% of the profits is coming from those 10 companies.
Dave:No close to 36%. That's where they traded much higher multiples than the total earnings forecast. So that opportunity to kind of close the gap by one contingent of stocks that have been the glamour stocks the last decade, coming down or plateauing as far as only following some earnings and the rest of the market starting to say let's lift up some multiples here. And oh, by the way, a lot of these companies have some pretty good earnings forecasts there is a value stock that becomes a growth stock is a phenomenal return story every single time.
Dave:And I think we're going to see a bunch of value stocks that start following their earnings. The market starts understanding earnings are going to continue to increase and decide they should pay a lot more for a lot of those companies and we're going to see a contingent of those companies that I believe have a very good rest of this decade in the equity markets, especially if the Fed is able to take rates down to 250 base points in the next year or so.
Ryan:So I think it was. Microsoft earlier today announced that they were going to increase the buyback of shares and they were, I think, going to boost their dividends as well. As some of those mega cap companies start thinking about what to do to grow and they maybe don't find as many options for reinvesting in growth, do you think that the reinvesting will just be acquiring some of their shares, like we've seen in the past?
Dave:I do, and the difficulty is Microsoft trades. It's a $3.2 trillion company. They're going to buy $60 billion back, so that's less than 2% of their float of their company's outstanding shares and it costs $60 billion. So it's not going to have as dramatic of an impact as companies like Apple in the past when they bought 38% of their stock back in the last decade plus and it's had a huge impact on earnings per share. But when you trade at that kind of multiple and you need to use Microsoft's free cash flow is in the $80 billion range, I believe last year or so. So if you're going to use $60 billion in a period of time and top of the dividend, which was an ordinary dividend increase about the same rate that they've done you don't. And additionally, they're spending a massive amount of money on capital expenditures. Obviously that doesn't hit income. It's fixed assets, but their cash flow is really spoken for and they can't really increase it.
Dave:So the markets I think Microsoft was up on that news, but not anything extraordinary that they're delivering to shareholders. I actually think it was a little bit more of a defensive move because shareholders are getting very concerned about that AI spend and a company like Microsoft that typically just a few years ago was spending $10 or $12 billion in capital expenditures in 2018-19. And don't quote me on those numbers, but they're in that range. I believe Next year is talking about spending somewhere north of $60 billion. So this is only five, six years ago that you're seeing this massive increase, and it's also a significant increase in your capital expenditures compared to revenue. That percentage increase is up from maybe 13 or 14 to about 21, 22 percent of your revenue. That doesn't seem like a sustainable model and I think investors have started to question Microsoft. So what's in it for us if you're going to spend all this money on capital building out the AI? And so today, I thought was more of a defensive move to?
Dave:say hey no, no, we're still in my back stock, but the market didn't applaud it, like you would expect them to do with those kind of numbers.
Ryan:I don't know if this is a good analogy or not, but it almost reminds me of what the energy sector did for a long time, where they took all their cash flow and they reinvested it and it wasn't capital expenditure and AI equipment, but it was trying to pull more oil out of the ground and gas out of the ground, but similar.
Dave:Clearly, investors got frustrated with that and then energy companies, after COVID especially, started really rewarding shareholders with stock buybacks and cash dividends and special dividends. In many cases, the sector first shrunk a small way. I mean, we're talking about very different return profiles, obviously, where you have margins in the tech space that are just magnificent. This is clearly the secular story of our lifetimes here, but energy is going to be around for a long time and energy companies figured out how to get higher multiples and to deliver cash in return to shareholders, and the tech companies could be in that spot one day.
Dave:There's no question that they're the dominant companies, but if I had to give you an analogy, I'd say Tom Brady is the best quarterback of all time, bill Belichick the best coach of all time, and I don't think that changed during either one of their careers. But for 10 years, from 2005 through 2015, they didn't win any Super Bowls. They were still just as great as they were, but somebody else won the day, and I think we're going to see that happen here across a continuum of a lot of companies as we move forward, that we're still going to have those companies being the best companies in the world, but where they're priced today, and the expectation on top of them means there's going to be a lot of other winners out there, not just the select companies that have dominated the last 10 years.
Ryan:Are there any specific, maybe underappreciated, themes that you think will be looking back five or 10 years from now? Investors will maybe kick themselves for not being exposed to, or maybe pat themselves on the back for having exposure to, that theme. Yeah, well, first I think small caps.
Dave:I mean they're terribly cheap. Rates are going lower. This idea that small caps won't be able to grow faster than large caps may be pertinent for a small period of time, and then history says they grow faster. I mean, I always just read Warren Buffett's shareholder letter. I can't grow Berkshire Hathaway as fast as I did in the past. It's much bigger. It's much harder to grow it. So certainly I think the small cap space is something that if your patient is going to deliver outsized returns because we're not trading at parity to large caps, we're not trading above what we've typically seen, that valuation, we're actually trading at a significant discount, not unlike the late 1990s. And then if you look at the early 2000s, you saw small and mid-cap stocks just dominate for four, five, six years and deliver outsized returns.
Dave:I actually believe we're in a market where you might not see the S&P 500 appreciate much. Obviously, it's incredibly top-heavy 36% of it almost is in only 10 names and eight of those names are the biggest tech companies in the world. They're tech-like companies only 10 names and eight of those names are the biggest tech companies in the world. They're tech-like companies. But you could see lots of portfolios perform. I'm not a big fan of the term stock picker's market, but this is a market where, if you're looking at fundamentals, instead of saying I need to hew to the benchmark which so many managers will do, so many retail investors will want that S&P 500 exposure.
Dave:We actually believe that as we go through the rest of this decade, the index won't do as well as lots and lots of other portfolios that have a broader bet on companies, broader sector exposure than what the indices give you and certainly less concentration in just a few more expensive names at the very top of the market.
Ryan:Okay. So we're, as I mentioned earlier, late September. That means there's an election coming up in early November. I think most of the odds makers say it's something like a 50-50 toss-up we don't know who the next president's going to be. Does it matter from a stock investor perspective?
Dave:It probably matters in certain industries. Although, if you look back historically, whether it's about green energy or oil, if you have a candidate who says we're going to get as much oil out of ground as we can, well, is that really good for oil companies? I mean, yeah, regulation's easier, but we're going to get as much oil out of the ground as we can, well, is that really good for oil companies? I mean, yeah, regulation's easier, but we're going to be washing oil, perhaps. And so maybe a candidate who says we're not going to allow a lot of oil to be pumped would be better for any company.
Dave:So you really have to decipher it Instead of trying to read between all those lines and figuring out on a coin flip. I think if you stick to the fundamentals the market and companies and entrepreneurs they look at the environment, they see where it's changing, where it might change, and they navigate it. And so does it matter? Sure, it matters to lots of people who the president of the United States is and make up of the Senate and the House, but as an investor, to get caught up on that, I think you make more mistakes than you make good possibilities for yourself.
Ryan:Okay, my last question for you, Dave. You are the Chief Investment Officer at First Trust. You've been the Chief Investment Officer for quite some time, but how long have you been at First Trust?
Dave:Been at First Trust since August of 1997.
Ryan:Okay, let's say you did not come to First Trust and you had a different career path. What do you think it would have been?
Dave:Not as good. I'm quite sure about that. I came out of school in 88 and I went to work for a public accounting firm in Chicago and I was there for eight years and probably would have stayed. I enjoyed it, I was okay at it and great. I got my CPA and I just had an opportunity through relationships to meet somebody at First Trust and end up here and never look back and never wanted to leave after six months being here. I would probably be some level of an accountant, more so than a finance person if I did not find my way to First Trust. So I definitely had looked into some accounting jobs and potentially CFO roles of some smaller companies but I'm certainly thankful that I passed on those and found First Trust in 1997. I passed on those and found First Trust in 1997. And it's been a great story of a company that is so unorthodox in so many of their ways of doing business, but absolutely something that I embrace and has been just wonderful for myself and my career.
Ryan:So I know I said that was the last question, but I have a follow-up question. So what aspect of working as the Chief Investment Officer at First Trust do you find most? You know what gets you charged up, what's most fulfilling, rewarding in that role.
Dave:Well, our model and I told you it's pretty unorthodox. There's no print advertising that you see anywhere. So what we do is we go on the road and we talk to thousands and thousands of advisors, and Brian Westbury is the chief economist he's the rock star. Jim Bowen is a fantastic CEO and is going to put this company together and then I get to just provide some market data and investment solutions for advisors who are serving their customers.
Dave:And that's my goal every single time that I go out on the road is and I start with, I want to give you something that can help you in a conversation with one family that you serve, mr and Mrs Advisor, that can help you, help them protect and build their wealth over time, provide for their family and their family's future. And the feedback that I get from that, you know, over the years has been just fantastic, and it's not about a single recommendation. I did this and you said to do that. It's no. Thank you for giving me something to show my clients so that I can help them achieve their goals, and so that, to me, is one of the most fulfilling things. And then the people at First Trust. I mean we have such a continuation of employees and many of the people I hired right away in 1997 are still there running different departments of the company and to see their growth and then the benefits that we've been able to give to newer employees, because we didn't have anything when we started building this thing.
Dave:Certainly, I got there six years after it started to be built, with 70 or 80 employees when I arrived, but the opportunities that you provide for so many other people and their families internally, it is pretty great to look back on. So we've got a long way to go here at First Trust, but it's been a wonderful ride.
Ryan:Well, dave, once again, thanks for joining us on the podcast, Thanks for all your insight and perspective, and thanks to all of you for joining us on this episode of the First Trust ROI Podcast. We'll see you next time.
