nInterviewWithDeniseChisholm
ectorStrategist,
delityInvestments
t’sTime
ToStop
Playing
Defense
yLeslieP.Norton
NISE CHISHOLM IS A SPECIALIST IN SEEING
tterns that others miss. That has made her
premely valuable to the fund managers at
delity Investments. A statistics enthusiast,
e divined in 2015 that the small increases in
ergy supply then occurring were worse for
ultiples than a contraction in demand. To
hisholm, that meant energy was a value
ap. The next year, many worried about a
ike in interest rates as the Federal Reserve
gan to tighten. But she showed that long
elds decline two-thirds of the time when
ading economic indicators are decelerating,
oviding a tailwind to the market. In 2017,
mid concerns about tech’s meteoric rise, she
ted that the sector’s valuations were in the
ttom quarter historically, while its operating
argins were in the top 10th, creating high
ds of outperformance. Says Bill Bower,
anager of Fidelity Diversified International
nd: “I love going through research with
r.” For the sector strategist’s current in-
ghts, read the following edited interview.
arron’s : How did you get started?
isholm: I studied statistical analysis, which
as my first love, in college. I studied law for
brief period, until I realized that I was
uch more interested in probability. At that
int, Fidelity was looking for people to give
atistical ballast to what they were seeing as
tical drivers of the overall market. This was
- At the time, most people really
anted to be fundamental analysts, and went
ep into stocks and sectors. I actually ro-
ted through all of our sector groups to learn
hat we call the critical drivers, a fancy term
“Rightnow,
wehavebad
newsglobally.
Youcanseeit
inthemanu-
facturingin-
dexes.More
oftenthan
not,for
stocks,that
badnewshas
actuallybeen
goodnews.”
for statistically relevant items. As much as my
title is sector strategist, I really think of my-
self as our in-house market historian.
What is market history telling you today?
The market is a discounting mechanism, and
we need to think about the signals and the
probabilities. Right now, we have bad news
globally. You can see it in the global manufac-
turing indexes. More often than not for the
stock market, that bad news has actually been
good news, given 1) the stimulus of negative
real rates and an increase in the number of
global central banks cutting rates, and 2) that
this is happening at a time of very rare signals,
where the market has discounted much more
than it has discounted in 20 years.
What are these rare signals?
The first is that, given the drop in Treasury
yields, real interest rates in the U.S. are now
negative. They’ve been negative a couple of
times in this cycle, and it happened a few times
in the 1970s and the 1980s. That is predictive of
an overall equity market advance and a cyclical
rotation away from defensive sectors.
Secondly, the Federal Reserve and the
European Central Bank are cutting rates to-
gether. That has happened only 10% of the
time in the past two decades. It’s a rare sam-
pling, but 100% of the time, historically, equi-
ties have advanced when this happens.
Thirdly, an inflection in the number of
central banks easing tends to lead a turn in
global manufacturing by nine months. That’s a
statistical way to say, “We need to be open-
minded as investors that the stimulus that has
been predictive in the past is in the pipeline,
and we’re at the point where this has histori-
cally translated into a rebound of global pur-
chasing managers’ indexes, which has led to a
rebound in earnings.
What does it mean for sectors?
With the PMI being below 50, 60% of the time
it’s actually not a recessionary indicator. It can
provide an opportunity to extend your time
horizon over the next year to capture double-
digit returns. It has also been predictive, even
at these levels, of high odds of a cyclical rota-
tion, where economically sensitive sectors, like
consumer discretionary, technology, industrials,
and financials, outperform those defensive
groups that we’ve seen sort of outperform,
year to date, like utilities, consumer staples,
and, to a lesser extent, health care, which
hasn’t kept up this time. Defensive is expen-
sive. Risk is cheap.
This confluence of rare signals, of low-
quartile manufacturing indexes, coupled with
global central-bank easing, has led to 16% to
24% average returns over the next 12 months,
versus the average of 8% Historically at least
to take advantage of double or potentially tri-
ple the market’s average historical return.
We need to be open-minded that, as much
as there’s a lot of bad news in the pipeline,
the market is a discounting mechanism and
might actually provide upside, regardless of
the bad news we see.
Aren’t you concerned about a recession?
Recessions are rare. The yield curve is a per-
fect predictor of recessions, but only in hind-
sight, with a wide range of timing. We had a
yield-curve inversion in 1966, and the reces-
sion didn’t happen until 1970. The shortest
stretch from inversion to recession was six
months; the longest was four years. After the
last two yield-curve inversions, in 2000 and
2006, the Fed raised rates three more times.
This happened at the same time as a commod-
ity-price spike. The two together equalled 150
basis points [1.5 percentage points] of [con-
sumer] income, quite a headwind. The lesson
from history, in my opinion, is that the yield
curve puts us on watch for a shock to the con-
sumer. Then, what you need is another shock,
like banks pulling back on lending. That’s the
tipping point.
A recession is not going to come from
where it came historically, because debt ser-
vice is at all-time lows, and the Fed isn’t rais-
ing rates; it’s lowering them. It’s not commod-
ities, because they’re only 3% of disposable
income for energy, goods, and services, and
statistically it needs to be about 5% to really
be a tipping point to destroy demand from
U.S. consumers.
What about the trade war?
If you have 25% across-the-board tariffs, it
will cost $125 billion to the U.S. consumer, or
a 75-basis-point hit to consumption. But if it
stops here, and we don’t layer on any more
shocks and the Fed stays accommodative, the
base case has to be potential expansion of the
economic cycle, which could provide above-
average returns with the cyclical rotation,
with leadership in technology, consumer
discretionary, financials, and industrials.
Going back to 1948, if we plot five-year
changes in global trade data versus stock
market returns, we find the highest returns in
the lowest five-year tranches of global trade.
In fact, the longer trade and tariffs are drawn
out, the more possible it is for the consumer
to absorb them, as disposable income grows
over time. Provided that income and jobs con-
tinue to grow, slow tariff increases would be a
headwind that could be overcome.
Assuming that we avoid a recession, what
sectors should one be in?
Consumer staples, utilities, and health care
are the most expensive they’ve been since
has been not just informative, but also predi
tive in history. It’s a rare signal that has onl
really occurred five times. You see a 1,000-
basis-point rotation back to the economically
sensitive sectors and an average underperfo
mance of the defensive sectors.
If you know that the National Bureau of
Economic Research is going to declare that
we’re going into a recession over the next
year, then consumer staples, health care, uti
ties, and the old telco services have 100%
odds of outperforming.
Consumer discretionary is the most intrigu
ing to me. We haven’t seen an economic reces
sion, but we’ve seen some rolling recessions,
right? Private construction has contracted, so
housing has been in a recession, despite the
overall economy expanding. The drop in inter
est rates has provided a catalyst, and we are
seeing some nascent recovery signs in home
sales. Importantly, home builders are at attra
tive valuation levels that have provided stron
odds of outperformance in the past. It’s a tri-
fecta of signals that I look for: contractionary
indicators, a predictive catalyst, and strong
valuation support. These historically have
provided an opportunity for [outperformance]
The consumer-discretionary sector has
changed, and it has improved its free cash
flow from cycle to cycle. And even in the las
recession, it really held up in terms of opera
ing margins and returns, which means that
relative earnings growth is in a much, much
better position to drive outperformance on a
forward basis. So consumer discretionary—
specifically home building—is a really inter-
esting sector.
Apart from the defensive sectors, what els
do you dislike?
Energy is really in a different place than it
used to be. The rolling recession that hit en-
ergy in 2014 marked the first time since 1962
that the sector actually hemorrhaged free cas
The big change in the energy sector has been
cash flow. As much as investors are pointing
the fact that it’s cheap, it depends on your tim
horizon. Going back to 1962, the sector’s earn
ings multiple is sort of average. It was cheap
in the 1960s, ’70s, and ’80s.
When I look at valuation being predictive,
being cheap on price-to-book ratios or any
other asset value provides sort of 50/50 odds
outperformance. What I want is five out of
seven valuation indicators to be in the bottom
quartile of history; that’s when you get clear
odds of outperformance. With energy, we’re
not there yet. It ticks off price-to-book, price
to-sales, and enterprise-value-to-sales. But it
doesn’t tick off [trailing] price/earnings, for-
ward P/E, price-to-free-cash-flow, and enter-
prise-value-to-free-cash-flow.
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