VISION 2026: Sectors, factors and markets in 2026 - Denise Chisholm

Host: [00:00:00] Hello, everyone. Thank you, Denise, for joining us today. Very excited about this session. Everyone loves hearing from you. Let's start with inflation. The latest numbers came out, what are you seeing in the trends? Is this sustained or is it transitory?

Denise Chisholm [00:00:14] We had some bumps at the end of last year. There was a big debate about whether or not this was sustainable or whether it was one time, you know, government shut down, the data's not clear. Look, I think we just got some interesting data in the productivity report which is unit labour costs, and that is really the gem of that report and it's the gem because it kinda combines the fact that wage growth is, in fact, decelerating still and productivity is increasing. These two things together are important because it usually does mean the disinflationary trend is likely more sustainable and more durable. You see that very clearly in history. What is interesting is that, look, there's still a lot of fear given fiscal stimulus and maybe with the Federal Reserve cutting, is there going to be another inflation scare? When you look at the data, and for anyone who wants to see the data you can go back and look at my charts of the week, this is a very clear juxtaposition versus the '70s and '80s when unit labour costs were rising on a sustained basis. Ours are in the bottom quartile of history. When you're in the button quartile of unit labour cost historically what you look at if you average what inflation is over the course of the next year, it's around 2%. And if you look what the Fed can do with that inflation, the Fed can cut till around 3%. I think that what we're seeing in terms of the start of the year, as much as there's fear about tariffs, there's fear about fiscal spending, there's fear about monetary stimulus causing inflation, the data is coming back to suggest that sustained disinflation could be a trend in 2026.

Host: [00:01:47] Great. And how does that impact your views on the secular bull market?

Denise Chisholm [00:01:51] It's definitely related. Back to that sort of unit labour cost trend, it does mean that the Fed can renormalize policy because they can. There's a lot of talk about the Fed, what will they do and what won't they do, the Fed itself is not important as it relates to the market. It is why the Fed is doing what it's doing that's very important to the market. If the Federal Reserve can cut rates because they can because inflation is in a sustained disinflationary trend, that tends to be supportive of the bull market. What's more interesting, and I think a clear driver of the bull market, is the durability of earnings growth. Now look, this cycle has been a very, very odd cycle. I always say that 2022 was kind of the landing for us. It was either a very hard soft landing or it was like a soft hard landing but we kind of landed, right?

[00:02:40] We had a profits recession. The profits recession as we emerged from that landing was very unique. It was the only time where cap-weighted earnings were growing but median earnings were still contracting. If you look at median earnings for the S&P 500 you will see that they have been in a sustained durable contraction akin to the financial crisis, to the dot-com bubble, to any other recession historically, and are just now actually emerging from that contraction. That actually gives much more ballast and durability. I think we have a very unique combination as to what inflation might mean. Inflation might mean, this deceleration means that the Fed can cut because they can and that increases the odds that the growth we are seeing on a median company is sustainable and durable. I think that that durability of earnings is what drives the secular bull market.

Host: [00:03:37] Just thinking about inflation, we'll stay on inflation for a second, I'll get back to the Fed. Thinking about inflation, how do you see it interacting with other macro themes like AI in the market as an example?

Denise Chisholm [00:03:49] We'll see in terms of AI. I think that the jury is still out on whether or not that is the reason behind the increase in productivity. I think it would be too early to see a sustained impact on productivity but we are seeing productivity rise. That might be bolstered in years in the future of sustained disinflation but I think there's a couple of things when you step back. I think that when you look overall, I think that there's still a knee-jerk reaction by investors to say, hey, look, if inflation's around 3% that's slightly above historical medians and that's certainly above the Federal Reserve target, isn't that a bad thing? You forget that that's actually the sweet spot for equity returns, between 3% and 4%.

[00:04:32] It's interesting, when you look at the historic data when you see top quartile inflation that's rising, that's above 4 1/2% rising, that tends to be a really bad setup for the market, and we saw that in 2020, but you have to be very careful because above top quartile inflation, 4 1/2%, and falling is the best setup for market. So it's an easy whipsaw. When you're in these middle quintiles inflation's not the driver. The Fed's not the driver. Usually earnings growth is the driver and that gets back to the durability of the cycle. The volatility of inflation is almost more important statistically than the level itself. Inflation's not particularly volatile around median levels. That allows companies to plan, companies to spend and the Federal Reserve to cut.

Host: [00:05:18] Speaking of that, you said earnings growth is strong right now.

Denise Chisholm [00:05:22] Strong enough. The interesting part is if you look at it ... we're just emerging from the median contraction so it is getting stronger. I think there are those investors who would like earnings growth to be stronger, certainly GDP growth to be stronger. If you looked at the most recent print for GDP, I think it was 4, 4 1/2, but if you look at the year-on-year increase, not the run rate but the year-on-year, it's like in the 2s. We don't really have very strong growth across the board in the US by any stretch. To me, that's like the best statistical indicator because that more likely makes it durable. The more it's grinded out, what do the kids call it, mid, mid-growth, that actually makes it more sustainable.

[00:06:05] The part that people always ask me, Denise, what keeps you up at night? It's the good data that keeps me up at night. From a probability perspective one of the worst things you can see is above 25% earnings growth, below 80 basis point credit spreads really peak OECD, LEI, leading economic indices, of a joint coordinated recovery. We don't see any of that. In some ways there are pockets of strength and there are pockets of weakness and when you average it all out it's kind of mid, and that means that the cycle could be much more durable than you think. That's what, ultimately, I think, justifies the valuations.

Host: [00:06:39] I've heard you say that best case scenario is we're just gonna grind it out. Is that still the case? Then can you just explain for us what you mean by grinding it out?

Denise Chisholm [00:06:49] Grind it out, yes, I think that that's still the case, is more like, let's call it 10% to 12% earnings growth. GDP growth that is like best case scenario gets to just above 3. That, to me, is grind it out. No top quartile event because top quartile event ... the real way as an equity investor you should be scared is from boom times. Those boom times end up showing up in really strong either earnings growth data or very, very tight credit spreads. By the way, we're not there based on the data that I look at, all of that. In some ways it gets back to the fact that the market is a discounting mechanism and you have to think long term. I think that there is a misperception of investors putting today's multiples, even if it's a forward multiple, on next year's earnings growth. That's not predictive of anything. It really is this esoteric like what do mid-cycle earnings look like and that's how valuation relates to it. That gets back to the durability of the cycle. If the durability the cycle is, in fact, something like 10 years, right, which is our prior economic cycles, and I'm saying sort of the landing might've been 2022, then mid-cycle earnings could be later than you think. Those compounded earnings could be more than you think. We could look back and say, hey, stocks were cheaper than we thought.

Host: [00:08:09] Actually, speaking of landing and cycles, people always ask where are we in the cycle, you've said 2022, soft hard landing, hard soft landing so we're basically still very early in the cycle.

Denise Chisholm [00:08:22] Let's call it mid just in some ways to put a finer point on it. When I look at historical probabilities and people ask me about the cycle in terms of what equities do or what the sectors within equities do, the only two times that you really see really strong probabilities is the six months going into a recession and then the six months coming out of a recession. Any other time I think the odds are really threadbare. Equities can go up, can go down in early and mid-cycle. Same thing is true of what people call late cycle. Late cycle can lag on for a very long period of time where you can see sustained bull market. I understand that we are going into year four of what would be double-digit years if we actually see the S&P go up double digits. That is fairly rare, historically speaking. We had a pocket in the '40s, we had a packet in the '50s, we had pocket in the '90s. For me, that rarity, I don't wanna bet on a historical anomaly but when you look at the data you do see that the pattern fits because in the prior times of the '40s and '50s and '90s you actually saw well below average returns in the two years prior setting up for that four years. That's exactly what we saw in 2020 and 2022. We did see that pattern.

[00:09:39] I do think that when I look at what the stock market is discounting, people usually say, well, isn't it all priced in? The interesting part is it depends on how you want to quantify priced in. I understand stocks are expensive and they're up a lot, as a quant if you just look at the data I wouldn't want to bet on those two things determining what stocks are discounting. If you look historically when you see stocks go up a a lot and you say, well, if they were truly discounting a very good outcome then I should bend the curve from a probability perspective. The more stocks go the less likely they are to go up in the future. You don't see that. You see the opposite of that. The more stocks go up the more likely they are to go up in the future. That's not to say 100% of the time but it should at least give you pause in using that as an investor to say, hey, I'm gonna pare back on equities because stocks are up a lot.

[00:10:31] Same thing is true of valuation. In all the quartiles of valuation what you see is the same odds, 75% of the time markets go up the next year. You think that I told you something, right? Stocks are expensive. You think you know what that means but the data shows that you can be wrong just as often as you're, more often than you're right because it doesn't really differentiate. For me, what seems sort of strange to say, the best indicator that I've seen that sort of bends those probabilities are fear in the equity market relative to fear in the credit market. It's a little quanty. I mean, you can measure it on the VIX or valuation spreads but this is the difference this cycle, right?

[00:11:09] There are a lot of differences this cycle and I try and concentrate on the differences and then seeing if there's patterns behind those differences. The difference, this cycle has been equities have been relatively much more fearful than the credit market since this entire five year span since 2020. That is historically the pattern that I'm looking for. The more equities are fearful relative to the credit market the more likely equities are to kind of go up in your face, which is a mathematical way of saying, look, I think that there's still the probability that whatever it is that you're afraid of that could go wrong equities can still climb the wall of worry despite the fact that this might be year four of double digit returns.

Host: [00:11:50] Just thinking about equities and valuation then, we don't see euphoria in the market. You've used the term euphoria, right? Does that make you feel more comfortable that ... we get asked all the time, are we in a bubble?

Denise Chisholm [00:12:03] Yes, that definitely gets me more comfortable because we're not outside any of those statistical anomalous zones that I would say bend your probability curve. As it relates to the bubble, there's definitely been a lot of talk about, well, maybe it was months ago, maybe its cooled down now, but if this has been a bubble from a technology perspective it's got to be one of the worst bubbles I've seen because technology only outperformed by 400 basis points last year and five of the seven Mag-7 I think underperformed the S&P 500. That doesn't strike me as particularly bubblicious. When you look historically people want to focus on six or seven companies, and we probably know who those six or seven companies are, for the last couple of years. They'll show you the CapEx hockey stick and they'll show you the free cash flow trend of steady and you'll say this is a big change.

[00:12:53] But if you just take a couple clicks back and look over the past 40 years you'll see that this looks absolutely nothing like 2000 where for the aggregate Russell 3000, companies were spending three and a half to four times the free cash flow that they produced in the bubble, were less than one. For the technology sector specifically, instead of outspending their free cash flow for the better part of 10 years before the bubble peaked we have now been outgrowing CapEx in a free cash low perspective for the last 20. This is just a very, very different setup. And, oh, by the way, instead of 70 times earnings the stocks are only 30 times earnings, which I think is what you usually pay for leadership. I mean, it's uncomfortable. Would we like to pay less? Sure but when you look at the predictive capacity, getting back to the bubble, if you said, okay, for the last 20 years when we've seen a secular margin increase for the technology sector you were given two choices. I'm either top quartile growth and top quartiles valuation, that's where we are, or top quartile growth in anything other than top quartile valuation, so I'm cheaper.

[00:14:02] And then you said, I'm going to buy those two scenarios, tell me how I do over the next year. You have better odds with higher multiples already. Why? Because multiples are just a reflection of how visible your earnings growth is. If that's right and earnings growth is, in fact, visible then it's not likely to be offset by valuation compression. Interestingly enough it was 100% historic odds if you were already in high growth, high multiples, that technology went on to outperform. So look, I think that nothing looks euphoric, nothing looks like a bubble, I think technology looks like leadership.

Host: [00:14:35] I was going to encourage everyone to send your questions in. We actually have a question from the audience right now. What are your thoughts on margin growth and are they close to cycle highs?

Denise Chisholm [00:14:44] Yes, margin growth is a secular advancing margin trend. Part of this is mix shift. You can do it a bunch of different ways but if you look at the mix shift with technology where I think it was, whatever, 10% in the '70s, now it's 30%, so just that mix shift itself into high operating margin companies will give you that secular trend. My thoughts on margin growth, back to that unit labour cost, it's really interesting. We only get the data quarterly but that's the best throughput from an economic data perspective on what margin expansion will do. The lower unit labour costs are, this is corporate America paying their earnings, so wage growth is decelerating, productivity is picking up, corporate America is getting more bang for their buck out of their workers, that is linearly related to margins.

[00:15:32] Again, if you're going in position is, okay, Denise, your thesis in 2026 is that there's durable earnings growth, there's upside to margins, are you getting confirmation in the data? So far we're getting good confirmation in the data. I do understand like are they close to cycle highs? Yes, and I understand the trees don't grow to the sky, Denise, but again, back to this secular trend that you've seen is something that I think you should be wary about betting against corporate America's ability to stay profitable. That's sort of what we saw during the pandemic as well.

Host: [00:16:06] Turning it to the Fed, I said I'd come back to the Fed, obviously, there's an interest rate announcement today. All probability is on a hold so maybe talk to that, and if they pause which sectors historically do well? What are the trends coming out of today if they pause.

Denise Chisholm [00:16:23] It's likely they pause and I think at this point you would say that by the time the Fed usually makes a decision it's fairly well priced into the market and sometimes you can see the back and forth of buy the rumour, sell the news. I think the real question is what the Fed will do over the course of the next year, not what they will do right now. They are on pause right now. My base case going in is that inflation, despite the tariffs that we will be lapping and sort of the disinflation that we continue to see in services that the Fed we'll be able to cut. The interesting flip of the Fed is, don't make this mistake because I think it's really interesting historically, is that always say, okay, well if the Fed, maybe expectations are for them to cut three times this year, I think its two or three, but maybe they only have to cut once, that's less supportive for the equity markets therefore maybe I should trim my equity exposure if I think that they won't be able to do that.

[00:17:15] No. Usually when the Federal Reserve doesn't have to cuts rates as much it's a reflection of growth. This is sort of an important nuance. I think that there again is this knee-jerk reaction to we need the Fed to be accommodative. No. We need the Fed to not necessarily be in the way of growth. The Fed follows the cycle more often than it creates the cycle. Usually even if rates don't go down as much as you thought if it's a reflection of growth the equity market has really no problem with it historically. As much there's a lot of focus about the Fed I think that that's more the noise than the signal in the market. How much they cut is much less relevant to why they cut. If inflation can continue to decelerate they can cut because they can. If earnings growth is strong and they cut less, well, that's good for the stock market too.

Host: [00:18:09] I've heard you talk about the term self-reinforcing cycle. What do you mean by that?

Denise Chisholm [00:18:14] There's two, I would say, things that we have this cycle that are a little different relative to what we saw coming out of the financial crisis. One is a CapEx recovery and the other is back to sort of the real rate trajectory of the Federal Reserve which perpetuates earnings growth. Let's talk about each. Let me talk about what CapEx means to me because there's a lot of debate in terms of how you can calculate it. We have our synthetic Russell 3000 that goes back to 1962 where you can add up all the capital expenditures, what corporate America spends on investment, relative to their sales base so I'm normalizing that CapEx trend. Anything that's increasing CapEx relative to that sales base I'm calling that a CapEx cycle. We have been, from that definition, in a CapEx cycle since 2022. That's a good thing because when you look back historically CapEx cycles are usually more durable for earnings growth and GDP growth. It makes a ton of sense. When corporate America spends they usually tend to hire. When they hire that money multiplier filters through and creates the virtuous cycle that we call the economic cycle. I think that that's data point number one that you can see that makes our cycle more durable.

[00:19:28] Data point number two is back to the Fed and inflation to the extent that the Fed can be in the bottom half of the distribution of real interest rates that tends to support the durability of earnings growth. Again, these are two things that didn't happen post the financial crisis. If you said what did that mean historically, it means that growth is more durable than you think which might mean that stocks are more justifiably expensive than you'd think. I wrote a lot of notes in the beginning of the year that said of all the things that are stickier this time or higher for longer I think we should get our arms around the fact that it might be valuation is higher for longer.

Host: [00:20:05] A question from the audience, are breadth and factor participation supporting recent market gains?

Denise Chisholm [00:20:10] Yes, there's always absolute breadth and relative breadth and don't confuse the two.  Absolute breadth is absolutely broadening out, if I can say that, and that has been true, I think, over the last year and you're seeing more and more stocks break out to all-time highs. Don't confuse that with relative breadth, meaning the percentage of stocks that outperform the S&P 500. That is also going up now which I think people say, oh, that's good because that's improving breadth. But what you'll find out is historically speaking having a narrow market, a few percentage of stocks outperforming the S&P 500, has very little relationship on the durability of the bull market. When people think about breadth really what you should be afraid of is what we saw in 2000 where one sector was going up but the other sectors were going down. We haven't seen that this cycle. Yes, it's supported by the absolute breadth and now we're seeing a broaden out on a relative basis as well. I think that those are both things that suggest that the secular bull market is still likely to continue.

Host: [00:21:09] I know you're avoiding the term rotation. You're talking about breadth and away from tech.

Denise Chisholm [00:21:13] Yes, rotation is ... I think last year when you look, when you snapshotted the year, there were basically only two sectors that outperformed, tech and tech-like, which is communication services and technology. Everything else more or less underperformed. That was definitely a narrow market so I expect, and I'm gonna use the term broadening, meaning more sectors outperform, historically speaking you see about five sectors outperform, that does not mean when I say broadening that technology will be an underperformer. I still think that the risk-reward is positive for technology. It would not surprise me if other sectors were better than technology and communication services but I don't think that you need to see a flip of technology underperforming and everything else outperforming. That would probably be a bad setup for the market overall which we saw for a short period during the tariff tantrum in April.

Host: [00:22:05] Leading into that what are your top three sectors.

Denise Chisholm [00:22:09] Technology, since I just talked about it, but in addition to technology, and for those who've listened to me there isn't gonna be any differences in my top three or my bottom three, the additions to technology have been the same which is financials and consumer discretionary look interesting to me. Financials, I wrote a note at the end of the year, it was like financials look interesting again, because I said it last year and I think I said it the year before. We've seen sort of this trajectory where, depending on your time horizon, they haven't outperformed by a lot but they haven't underperformed by a a lot either. What's interesting to me is that valuation is now back to the bottom decile which is kind of where we started the last three years. What you see is statistically that improves your odds, even every five-year increment since the financial crisis. Valuation provides a floor which I think, look, it doesn't guarantee that there's any upside but I like it when you have that potentially limited downside and you got the call option was what if something goes right? Which is a lot like, to me, parts of consumer discretionary, which is to say housing specifically which is interest rate sensitive, and the consumer discretionary sector overall. I mean, sentiment bottoms are usually the time you should be looking at consumer discretionaries stocks. That's the interesting part. There's really this bifurcated odds because by the time consumer sentiment is poor who doesn't know that it reflected poorly on the stocks, the stocks have usually underperformed, and you get this juxtaposition where there's opportunity. Those are my top three sectors which I find interesting.

[00:23:36] The bottom three, again, back to this durability of earnings growth  I think you still wanna be away from defence. Here I upgraded health care a couple clicks but I'll still pick on utilities and consumer staples that have much worse fundamental trends, specifically for consumer staples, than they ever had historically. Even when you look back in history you have to be careful which historical data would you like to use. When consumer staples was good in the '80s and '90s it had much better fundamentals. Now it has the weakest fundamentals that it ever had in the data that I have going back to the 1960s. I still think that that more or less looks like a value trap, along with utilities that usually are more defensive in nature. That doesn't mean there's not parts of utilities that are tied to the power structure but the XLU or the overall S&P utilities I still thing is a negative risk-award.

[00:24:23] Then I'm gonna add in energy. Energy to me, we can debate energy looks like defence, my biggest problem with energy statistically speaking is just how much money they made in 2022. We're still above historical medians in terms of ROE, in terms of operating margins. When you look historically speaking that sets you up for more downside on earnings. When there's more downside on earnings in energy sector valuation doesn't usually save you. Energy is the very rare cyclical sector where you get trough multiples on trough earnings, which means that if you're too early you have a lot more downside there than other places where you're usually mitigated with valuation expansion. Those are my bottom three, consumer staples, utilities and energy.

Host: [00:25:07] I'm gonna come back to commodities. We have a question from the audience, are volatility signals suggesting some complacency in the current market?

Denise Chisholm [00:25:14] That's a great question and one I love to talk about because it's all about asymmetrical signals. The VIX, when it's high you want to buy the market, everybody kind of gets that. You would think, okay, so when the VIX is low, or any volatility signal is low, that means I want to sell the market. No. It's just not that easy. The same thing is true with sentiment. Bearish sentiment is a buy signal, is bullish sentiment a sell signal? No. You get average market return. There's an upside skew. That's why I only talk about it when you get these abnormal variables because the rest of the time you sort of say, well, it's just in line with historical averages and is not providing me any signal whatsoever. The way to think about it is, and there's a chart out there somewhere, I never produced it but there's chart out somewhere, if you say when the VIX is, let's just call it bottom quartile so maybe below 16 or something like that, and you shade the S&P you will see that the biggest portion of the bull market move is when the VIX is complacent.

[00:26:08] Just be wary of using that as a sell signal for anything that's like, look, if you want to day trade or three-month signals, be my guest. My time horizon is usually about a year. I think that that can lead you astray because usually when there's complacency there's a reason behind it. Because earnings growth is visible, because there was a tax cut, or there was a refund, or there was a reason for that and just because it's, quote, consensus, doesn't mean that it's not durable.

Host: [00:26:36] I want to get to a question I get asked a lot about gold and silver and supply and demand, how we balance that demand with the supply.

Denise Chisholm [00:26:44] Gold and silver are very, very different than the rest of the commodity stack. You're asking somebody who studies history. If you're asking somebody what could it mean, I will tell you what it has been correlated to. My answers are going to be a lot different than other people. What you can see is the supply and demand shift very clearly in terms of central bank buying for gold and silver. When I look back in history and you say, okay, what is gold most correlated with, sometimes it's positive real interest rates, sometimes it's negative real interest rates. Sometimes it's dollar appreciation, sometimes it's dollar depreciation. There has not been a consistent correlation. Gold changes its stripes most of the time except with commodities. Why? Because at the end of the day gold is reflective of supply and demand. Okay, so gold is up a lot because there's more demand than supply. Does it have a meaning? Does it mean that there's a debasement trade as it associates with the dollar? Does it mean we should be worried as equity investors?

[00:27:44] I looked at the data going back to whatever it was, 1973 when gold started to float and when you look at the annual data you say gold's up a lot, does that mean that equities underperform or have a lower than average upside? The answer is no. It's the same, back to that asymmetrical signal, it's the same odds of advance, 75% of the time equities go up, with the same average returns, 8%. That doesn't mean that we didn't see something like that happen in the financial crisis but it does mean that I think I would be wary betting on that based on the historical data that gold being up a lot means anything other than there are more central banks buying gold.

Host: [00:28:24] We are at lunch. We have an hour break for lunch. Everyone, please join us back here at 1:00 to hear from Andrew Marchese, our chief investment officer. Thank you very much, Denise.