Good News on Inflation & Investment Rules to Live By (With Ned Davis)

KATHY JONES: I'm Kathy Jones.

LIZ ANN SONDERS: And I'm Liz Ann Sonders.

KATHY: And this is On Investing, an original podcast from Charles Schwab. Each week, we analyze what's happening in the markets and discuss how it might affect your investments.

Well, Liz Ann, it seems like the main event this week in terms of the economic data was the CPI number released Thursday morning. It certainly looks like good news. In your view, what does it tell us about inflation and the state of the economy?

LIZ ANN: Yeah, it was good news. You saw the month-over-month was a decrease, importantly. And one of the ways of looking at inflation that the Fed is focused on, even though CPI is not their preferred measure, are multi-month annualized changes, kind of a moving-average look at the trend. And the three-month annualized change is now down to 2.1, which again, it's not their preferred metric, but that's pretty darn close to the Fed's target. . And interestingly, on the day of release of the CPI, we also got a better-than-expected claims number[1]. So maybe one day of data doesn't reinforce this, but kind of Goldilocks-esque in getting lower claims, which of course is a good thing alongside lower inflation. So I think on balance, it was positive.

You know, one of the ways you can track what probabilities are associated with "Will they? Won't they? When?" in terms of the FOMC meeting and the start point for rate cuts is looking at fed funds futures. So the CME, which is short for the Chicago Mercantile Exchange, has a FedWatch tool that you can pop on very easily, and it showed about a 12-percentage-point jump just from yesterday to the day, as you and I are taping this, the day of release of CPI from less than a 70% probability of a rate cut in September to now more than an 80% probability. That's been our collective thinking that September was a likely start point. I'm guessing the data today, Kathy, only reinforces that you and I were just chatting before the tape rolled about when they might telegraph a September cut. So I'd love your thoughts on that for the benefit of our audience, too.

KATHY: Yeah, I agree with you. Really, really good news. One of the underlying details in this is a drop in the inflation rate in housing. Everybody's been waiting for the rents and the owner's equivalent rents and the cost of housing to come down. We know there's a long lag, and the Fed knows there's a long lag in here.

And it looks like it's finally really kicking in, and that's very good news if you're kind of tracking the underlying indicators. I also saw some easing in auto insurance. Another one of those things that has been very sticky and very difficult. So all in all, I think if I were Fed Chair Powell right now, I'd be doing a little jig around my office desk, saying, "Yay! We're getting there! We're getting there!" In terms of the Fed and what they're going to do, the market has built in now several rate cuts over the next year. I look at the two-year Treasury yield, and that's a good indicator of where the market thinks the fed funds might be a year from now, and that's around 4.50. So that's about 100 basis points for rate cuts over the next year, which is probably even less optimistic than it should be. Probably going to look at a little bit more than that.

In terms of timing, I would say we've been expecting the first rate cut to come in September and that the Fed would signal that at the annual Kansas City Federal Reserve meeting in Jackson Hole, Wyoming, in late August. There is a meeting in July. It's possible the Fed could use that meeting to give us a signal that they're getting ready to cut.

But it may still be a little bit too early for various members who want more confidence about inflation staying down. And as you noted, the jobless claims figures show a little bit of improvement this time around. So I tend to think not in July, small chance of any real activity at the July meeting. But then we can focus on late August and then an actual cut in September.

You know, we'll see how the data play out. And for right now, it's good news. And I have to think that the Fed is pretty pleased with the way things are going with their patience about this.

So Liz Ann, how about you tell us a little bit about our guest today?

LIZ ANN: Yeah, so I'm excited about this one. Our guest today is Ned Davis. He founded the Ned Davis Research Group in 1980. I think I've known Ned since maybe '88 or '89. And he has been professionally involved in the stock market for more than 55 years. He started in 1968. Ned believes that forecasting reliability or, and let's do air quotes, though you can't see it, "being right" is impossibly difficult, couldn't agree with that more. And he espouses a philosophy that he feels can consistently win through a disciplined strategy of following the weight of objective indicator evidence. Because Ned also believes flexibility is crucial, his company produces many sentiment indicators that I've been following for decades, warning investors to be wary at crowd extremes and helping them be open minded about potential trend changes.

Ned is a self-proclaimed risk manager. He dedicates his and his firm's research to avoiding major mistakes, cutting losses short, and letting profits run. Ned's also an author. He wrote Being Right or Making Money, as well as The Triumph of Contrarian Investing. And he has been the subject of numerous feature interviews in Barron's, has been a featured guest many times on, a man very special in my life, historically, the late Louis Rukeyser on Wall Street Week.

And Ned now serves as the senior investment strategist of the Ned Davis Research Group.

So Ned, again, thank you so much for joining us. This is a real treat for me, so we really appreciate your time.

NED DAVIS: Well, thanks for having me.

LIZ ANN: So I'm trying to remember, I don't remember precisely when I would have met you. It was probably sometime in the late '80s when I joined the Zweig/Avatar on the Avatar side group in 1986, and it was probably within a few years after that I probably met you. And I don't want to spend our time rehashing history and going down memory lane. It may not as be as interesting for our listeners as it might be for me. But just talk a little bit about your start in the business and what led you to form Ned Davis Research, which I think the start of that was 1980, if I'm correct.

NED: Well, I started in the business in 1968 with a company called J.C. Bradford and Company, which was a Nashville, Tennessee-based brokerage firm at that point and one of the largest ones in the Southeast. And I was there from 1968 to '80 and was eventually made a partner there. I met Marty sometime in that period in the '70s. He was doing some work, and I think he wrote me an email, and we just hit it off really well, because we saw the market, I think, a lot in the same way.

But anyway, it was interesting there that when I broke up with J.C. Bradford and started Ned Davis Research, one of the things I thought I wanted to do there—I'm not a very tech savvy person, but I just felt like this business was headed towards computers. And I wanted to put all the technical work that I had done, all the work I had done, on the computer and draw graphs on the computer. And it was a lot of work back then. In fact, in 1968, we were closing one day a week in the stock market because volume, which was 25 million shares a day or something, was just too much for the back offices to handle. So they would actually cut the Wednesdays for sort of like holidays in 1968. So it was really an interesting time. Wall Street just had not become computerized at that point.

So anyway, I had big plans for doing that, and J.C. Bradford said, "Well, if it's not broke, why fix it?" And so I really left there basically with a couple brokers from J.C. Bradford to start Ned Davis Research and go computerized. And that's what we did, and I guess that's sort of an interesting little satellite.

LIZ ANN: Well, one of the things that's most impressive about you and your organization is the history and the databases and how far back you can go. And you and your team have done wonderful projects for us over many, many years. So to have had that, not being a tech savvy person, which I'm not either—in fact, something goes wrong, I'm an unplug, plug back in, if it doesn't fix it, then I have no idea what to do. But you had that vision to understand the importance of, you know, a quantitative component to the research. And at Schwab, we've certainly been very grateful for that.

You know, speaking of which, you've often described what you all do at NDR as 360-degree research. So I'd love you to explain that to the listeners, because I think it's an interesting way to think about analyzing the market and the economy.

NED: Well, Wall Street usually breaks down between fundamentalists who look at sales and earnings and company prospects and technicians who look at charts and how a stock is acting. And then there's a few people that think the stock market's really driven by crowd psychology. So they're sentiment people, but it's a small group.

So we just felt like, you know, all these things really feed into the market. So we decided to be a combination of, you know, fundamentals and macro and sentiment and technology and momentum. And we just tried to put it all together as a 360 degree. And we're very big on a weight-of-the-evidence approach. Very rarely do all the indicators line up on one side. This is really a … it's a cloudy business, and there's black and white—and people buy, they think it's all black, and people sell, they think it's all white—but it's not. And so most people on Wall Street take one side of a position and sort of hold your hand to that side. But we sort of give both sides, but we try to come down on one side or the other using the weight of the market evidence.

LIZ ANN: You know, you mentioned sentiment as a component of that—and having known you and your company's research for three and a half decades or so and having … I sort of grew up in this business right out of college and then for 13 years working for Marty. I am a student of sentiment, and I think the work that your firm has done, and the creation of the Crowd Sentiment Poll, has been terrific. But I also like, to your point, how you blend it with momentum. And I know your thought is always, you know, sentiment at extremes, as a backdrop, is a contrarian indicator. But as long as the trend is moving in an upward direction, as long as there's that momentum, that tends to trump sentiment. And you also have an interesting take on sentiment. It's not so much just getting to extreme, but when it starts to reverse from an extreme. So just share some of your thoughts on investor sentiment—maybe importantly these days, how either the backdrop has changed or your research on sentiment has changed because just the functioning of the markets and the players in the market are so different relative to when you started in the business.

NED: We have a rule, and Marty used this all the time—don't fight the Fed. If the Fed is tightening, it doesn't take a whole lot of optimism to be peak optimism and be a high risk. On the other hand, if the Fed's easing, it takes a lot of optimism. It takes everybody in the market to get to be a problem. So we look at sentiment with the tape. We also look at sentiment with the Fed.

At the present time, sentiment's interesting because stock market sentiment really is excessively optimistic. But when you move away from the stock market and look at sentiment—I mean, you can look at any poll you want and ask people if things are going well in the U.S., and they say no. There is a gloomy side to the economy, which we could go into. I think it has to do with, you know, what bracket you're in and income level. But sentiment's interesting because it's not a one-sided, clear-cut case. So you know, you look at consumer confidence from the Conference Board or the University of Michigan—they're, you know, showing a little confidence but not the kind of thing that you see at extreme optimism where you really get into problems.

LIZ ANN: Yeah, you know, I'm glad you mentioned maybe a lot of the differentials in sentiment as a function of where you maybe sit on the income spectrum. And you wrote a recent report—I think it was, I don't know, a week or two ago—talking about the K shape in sentiment. And it often is based on, in the case of the stock market, either your income or whether you actually have exposure to the stock market—whether you're participating in the appreciation associated with the stock market. And we've been writing at Schwab a lot about sort of K-shaped bifurcations in the economy.

Do you find that incredibly unique in this environment, or do you see parallels to this type of K-shaped backdrop, whether it's sentiment or just economic data? So this is sort of also a broader question, given your long tenure in this industry. Does this feel or look like other times in history, or are we really in a very distinct period of time?

NED: You know, anybody who's studied the economy will tell you that the stock market is a fairly accurate leading indicator of stocks. And yet stocks are a fairly small part of the economy historically. However, since 2000 or, you know, now, the stock market is almost double the size of the economy. So the so-called what economists call the "wealth effect," which has always been there. But you know, when stock market goes up, people feel better, they spend more. Stock market goes down, they worry, and you know, they spend a little less. But now the stock market is so big relative to the economy that it may be the most important macro factor going.

And then when you turn around, you say, "Well, who owns stocks?" Well, a lot of people own stocks. They have pension plans, they have 401(k), and so forth. But really it comes down to about the top 10% of the economy really owns stocks. And so when the stocks go up, it really affects those 10% so much more. I mean, everybody watches the news—stock market's making record highs, they feel pretty good. But it really affects those people. And unfortunately, the average person does not own much in the stock market and is not as much affected by it.

So the stock market itself has really been driven by about ten stocks. You know, out of the S&P 500®, ten stocks is nothing, but those ten stocks now are 37% of the stock market. So those 10 stocks are driving the stock market, and the stock market may be driving the economy more than it ever has. 

So you know, the concentration's been high all during the last three or four years of this bull market. The market keeps on going up. It's not the concentration itself that's inherently bearish. It's risky, but it's not a bearish factor as long as the rest of the market is also moving up. And that's been true until very recently. I'd say in the last two months, a lot of stocks have just failed to participate here and actually have gone down while the market's going and doing so well. So I'm a little more concerned about it now. We're still bullish. The trend's still bullish. We're still bullish for overweight stocks, but it's a risk factor that I'm aware of and people should keep on top of.

LIZ ANN: So when you express bullish or bearish views and exposure guidance, who's the primary audience for that information? Because you obviously have big organizations like Schwab as clients. So what are you targeting when you express those views—whether it's just general optimism or pessimism about an asset class or allocation type recommendations—who's the listener? Who's the audience for that information?

NED: Well, when we started the company, we decided let's try to find clients who have the money, and you know, where's the money? The money's in the institutions. So we decided to focus on institutions. And understand this, but if you want to do business—you're in the brokerage business, you want to do business with retail, you've got to be registered in every single state where you have a retail client. And we decided not to be a retail firm and to be an institutional firm, and so that's what we did.

LIZ ANN: You end up indirectly being a firm that retail investors care deeply about, in part due to firms like ours.

NED: I wouldn't be on this podcast if I wasn't interested in retail at all.

LIZ ANN: Right, because our entire $9 trillion are retail investors, and you know, some of the most important research that we share is in partnership with you. So what you do with the precision around bullish, bearish targets is geared to an institutional audience. And I think that makes sense for an institutional audience. I'm often asked, "Well, why don't you do things like year-end price targets or share what percentage you think clients should have in equities versus fixed income, etc.?" But again, we have $9 trillion of retail clients, and to just have one answer to that doesn't make sense. But I think it helps when we're sharing your type of information to just have that context. And so I wanted to put that in as a question just to make sure our listeners kind of knew the connectivity, you into the institutional world, but how it filters into the retail world through firms like ours.

Another topic that you have written about extensively over the many, many, many, many years I have been getting NDR's research is on debt and the deficit. And I have to say, Ned, I do client events all the time. The number one, almost always first question I get is on our debt and deficits. And they're usually pretty general questions. And what I find is that I think the investor class cares deeply about this. I'm not sure the average kind of constituent, if you want to call it that—they might care about it in the abstract, but they're not voting typically based on it. But you've done such phenomenal work, especially the impact on economic growth and its components from having a high and rising burden of debt. So I'd love to just share your thoughts in general, but your current thinking around, especially given that the deficit, the CBO just kind of whiffed on their estimate for the deficit just this year. But I love your broader thoughts and just how much history you have that you've put into your thinking around debt and deficits.

NED: You know, one of the things that we try to do that I think is different than some other people is that we try to look at items globally, or we try to test them globally as well. And so debt is one of those items. We did the work on the U.S., and it showed generally that high debt tends to lead to lower growth and surprisingly lower inflation because people are trying to service the debt, and it slows down their spending. But then we went out and we found the similar data from around the world and it was … I think we had 14 or 16 different countries, major countries—and in every single case, growth was better with low debt than high debt. So you know, you really feel much more comfortable about discussing a subject when you can say, well, "We've tested this, and it's not just in the U.S. It's globally."

The one point I would make, however, is that it's not so much debt as it is debt service that's really the key. And we had a major debt problem, and we saw that in 2008-2009. I mean, we came very close to a collapse there, and what the Fed did was just open up the spigots and print money and also brought interest rates down to zero. And therefore, at zero rates, interest service became much more easy to handle. And so that's where we were, and we did that for a decade. And it went pretty well, and debt was not a big problem.

Now of course interest rates have started to rise again, and debt has continued to grow throughout this period. So it's more of a problem, but we don't really think it's critical yet. And the reason is because during that ten years, people refinanced their mortgage. Mortgage rates are 7% now. They're a little over 7%, but the average mortgage out there is about 3.5 % for people that have mortgages. So they're not paying the 7%. If they were paying the 7%, this economy would look very different. And this is true for car loans and everything else. So yes, this is a problem. I would say one thing is this is why it's taking longer for Fed policy to bite because people are refinanced at very low rates. Corporations did.

Actually, corporations as a percentage of their profit—their debt's at record highs, but their debt service is still relatively low. But they're going to have to refinance. So in other words, this Fed tightening—even though the Fed's quit tightening and actually is going to loosen a little bit, we think, this year—those interest rates are still going to go up on that debt, and it's still going to bite a little bit.

LIZ ANN: Do you have a … what you're penciling in in terms of the point at which the Fed starts to ease and by how much … this parlor game that everybody wants to play of, "Will they, you know, in July"—probably not. "September—how many, one or two?" What are your thoughts and your firm's thoughts?

NED: Our firm's position is they're going to cut once and probably in December. And we said September is an open question. My own feeling is there'll be two cuts, and one will be in September.

LIZ ANN: And that's based on a positive outlook in terms of disinflation trends or the labor market coming into play as a justification for the Fed to ease an advance of inflation hitting their target?

NED: You know, Fed has a dual mandate, and all they've talked about really for the last three years is getting inflation down towards 2%. But in recent months, they've said, "Hmm, you know what? We've got a dual mandate, and the other side of the economy, while still solid, is not as strong as it was, and therefore we've got to look at inflation too." And the unemployment rate's gone from 3.5 to 4.1%. Historically, that's big enough to suggest the economy is weakened quite a bit. So I think that's why they're going to cut in September is because the unemployment thing is enough of a risk now to be on the radar.

LIZ ANN: I want to go back, not specifically to concentration or the largest ten names—but given how we started our conversation talking about your use of computers before they were well known or popular, I wanted your thoughts on AI. And maybe in general, and are you and your colleagues at NDR incorporating it into any of the work that you do?

NED: Well, we're trying to. You know, I think AI has the potential, at least in terms of building software and programs and so forth, to do a lot of good and help productivity. So I think it's an important subject. You have a handful of firms that are dominating it, and the cost of the chips are so expensive that it's keeping everybody else out. First of all, they had the technological knowledge, but the costs are expensive. And I think it's a big deal. I wouldn't say it's as big a deal as the internet was, but it's still a big deal, and it's been a great help for this market. However, I would say at every single market peak, there's been something. There's been some narrative of some new, great thing that's a new era and it's going to change all our lives. And it does, of course. You know, you went from a horse and buggy to a car, but still things tend to even out over time.

Another factor in the market concentration, because it is only in a handful of stocks—what we found is, I guess, is economics, but the law of diminishing returns. In other words, when you get to be so big, it's hard to generate 20%, 30% profits in a year. When you're small, you can do that easily, but the bigger you get, the harder it is to make those numbers. And there's a whole stack of statistics on this, and it's held up.

And so yes—AI is another big deal, just like the dot-coms were, just like energy was in the 1980s, just like RCA was in 1929. But, you know, life goes on, and these companies can't grow as fast in the long run.

LIZ ANN: It's great to talk to somebody with as much history as you to remind people that there are always shiny new objects, and they can be transformative, but it also can develop into hype and too much enthusiasm and valuation excesses even if the innovation itself is a game changer. So it's always important for somebody with history as long as yours to, I think, remind investors of that. And I wanted to close more broadly on that.

You've written about, and I've seen you in interviews, talk about sort of the rules to live by—the investment rules to live by. And given that you started in this business 56 years ago, if I'm doing my math correctly—what are your investment rules to live by, and have they been consistent or have they changed?

NED: I think they've been consistent. I would say one thing—you know, you can come up with a rule. Alan Abelson wrote this up one time. He said, "Just about the time you learn how to play the game, they change the rules." If an indicator gets too popular, and everybody follows it, it's just not going to be as useful going forward as it was in the past. So this is why I think psychology is so important to put in the mix here.

I wrote a report on the bubble of 2000, and I, you know, I did a lot of work there on the dot-coms—and they said, "This is not a bubble. This is the internet. This is the greatest invention in the history of man. This is going to change your life." And they were right. They were right. But it didn't matter because there was too much popularity, too much excitement. Now we're not seeing … we saw so many companies, new companies, start around 2000 that it became a problem. And we're not seeing that with AI yet. So hopefully it's a little earlier phase. You're going to see a bunch of software companies—they're all going to want to have products that use AI to make your life better. And that's going to be a more concerning phase.

But yes, the, "Don't fight the tape, don't fight the Fed. …" I mean, Marty used this. You know, we used this all during the '60s, and called the 1987 crash and things after that. These rules are pretty timeless. But the sentiment thing, I think you have to put in there, because, you know, let's say the yield curve—that's a great one—everybody said, "Well, the yield curve is the single important indicator that tells you you're going to have a recession." If you go around and look at globally, the yield curve caused a lot of recessions, but Japan had recession after recession with a positive yield curve. So there's plenty of cases globally where the yield curve didn't work. You can't just … when everybody says, "This is the indicator to watch," that is a problem. Psychology tells you that's a problem. And so from that standpoint things have changed, but otherwise no, the basic rules—human nature doesn't change. You go from greed to fear panic. John Templeton said way, way back when, "Bull markets start with fear and panic, and they grow on skepticism, and you know, they die in … top on confidence …"

LIZ ANN: "In euphoria." Yep.

NED: "… and euphoria kills them." And you know, that just becomes timeless as far as I'm concerned.

LIZ ANN: I couldn't agree more. That's my favorite, I think, thing ever said about full market cycles was the Sir John Templeton quote. And I think what I love about it is there's no word in there that has anything to do with valuations or what the Fed is going to do or earnings. It's just on psychology. And so thank you for sharing that.

And thank you for sharing your time. Again, I have been an avid reader of your work, and I reminisce all the time about my days with Marty and the seminal work that you both did. And you've just educated so many, myself included, so I appreciate your time, Ned. Thank you so much for joining us.

NED: Thank you.

KATHY: Thanks for that, Liz Ann, a really interesting interview. So looking ahead to next week, we have some more corporate earnings coming out. What else will you be watching?

LIZ ANN: Yes, obviously earnings are important, but it's also a week where we get retail sales. That's increasingly important, obviously, to gauge the health of the consumer. It doesn't tend to be watched much, but import and export prices just to get a sense of domestic pressures or lack thereof on inflation, but also international pressures. Business inventories come out, that in this part of the cycle is interesting to see whether inventories are building. We also get decent amount of housing-related data. The National Association of Home Builders (or NAHB) has a housing-market index that comes out, and that's widely watched, and it's in conjunction with housing starts and building permits that also come out, and those are key leading indicators. We get industrial production and capacity utilization. Claims obviously, we want to see if this most recent downtrend in claims, which again is a good thing, persists, and then the leading economic indicators.

I think we also, correct me if I'm wrong, Kathy, we also get a Beige Book. Is that on your radar? And or what else is on your radar in the next week?

KATHY: Yeah, we should get Beige Book, and we should get, I believe, the GDP price index for second quarter with the core PCE number, which is, of course, the inflation index that the Fed watches most closely. Those will be very important numbers. And I think in general, too, waiting to hear the Fed speak to see if the tone improves amongst more members. We've had hints that they're getting happier with the inflation trends and the way things are going from a couple of members. But you really need to hear more of a cacophony of voices saying, "Hey, things are going well," or to have them be really cautious still and have some of the hawks, the people who still are very, very much on the fence about cutting rates, need to hear a little better tone from them. So that's what I'll be listening for next week.

So as always, thanks for listening. That's it for us this week, but you can always keep up with us in real time on social media. I'm @KathyJones, that's Kathy with a K, on X and LinkedIn.

LIZ ANN: and I'm @LizAnnSonders on X and LinkedIn. The social media sites, the only two that I'm on. I am not on Instagram. I am not on Facebook. So if you see any posting there that claims to be me and saying I have some private stock-picking club and then taking you down a rabbit hole of paying for that via WhatsApp, it's not me. Please don't get duped. This is a really brutal problem we're dealing with, but Schwab is trying to be all over it with the folks at Meta, but those are not me. I am not active on Instagram or Facebook. 

Now, back to our podcast, which is real and legitimate. And if you've enjoyed the show, we'd really be grateful if you'd leave us a review on Apple Podcasts or a rating on Spotify or any feedback where you listen. You can also follow us for free in your favorite podcasting app.

We are off next week, but we'll be back with a new episode in two weeks. So stay tuned for that.

KATHY: For important disclosures, see the show notes or Schwab.com/OnInvesting.

[1]* Claims = initial jobless claims reported by the Department of Labor