Schwab's Liz Ann Sonders talks about gambling vs. investing, where the real AI story is being missed and what the Fed will - and will not - do next

Liz Ann Sonders, chief investment strategist at Charles Schwab.

'Investing is about owning. Gambling is about hoping.'Liz Ann Sonders

Liz Ann Sonders has spent decades translating the complexity of financial markets into language that retail investors can actually use. As chief investment strategist at Charles Schwab, she has the ear of millions of individual investors and has become one of the most recognized voices in the country on what markets are doing and why it matters to the average person.

In this interview, edited for length and clarity, Sonders explains the single biggest mistake retail investors are making today, why she believes the line between gambling and investing is dangerously blurred, what valuation metrics actually tell you and what they do not, and why the Federal Reserve is unlikely to cut interest rates anytime soon.

MarketWatch: What is the biggest mistake retail investors are making in this market?

Sonders: Probably a lack of some of the traditional disciplines. Also, not focusing on diversification, and most importantly, not rebalancing periodically. Investors let their winners run and bail from the losers.

I also think a lot of investors are jumping in with a trading approach, particularly younger investors, as opposed to going through the process of establishing a plan and figuring out what their strategic asset-allocation should be.

I often ask an audience: what is the most important piece of a jigsaw puzzle? People say the final piece, the corner pieces, the edge pieces. I always say it is the picture on the box. If you are doing a 1,500-piece puzzle without looking at the picture on the box, it is an impossible task. That is what investing without a plan looks like.

And then there is leverage. The popularity of leveraged ETFs, particularly leveraged single-stock ETFs, concerns me. I am not sure that all retail traders understand the risks associated with those products.

MarketWatch: What do most investors consistently get wrong about the market?

Sonders: What they consistently get wrong is greed and panic, the classic extreme emotions. The late 1990s were a perfect example of greed. The global financial crisis and the bear market of the early 2000s after the internet bust were driven by fear and panic. Panic is not a strategy.

But there is something bigger happening right now. I think it is a good thing that there is more interest in investing, particularly among younger people. But there has been a dangerous blurring of the lines between gambling and investing.

Investing is about owning. You are a participant in wealth creation, in the cash flows of businesses you own a piece of. Over a reasonably long period of time, the odds are in your favor.

When gambling, you place a bet, step back, and hope for a windfall. The odds are not with you. The marketing of betting platforms, sports or otherwise, and prediction markets is helping blur those lines. Studies of younger investors show they believe gambling is a reasonable path to wealth creation, not all that different from investing. That concerns me deeply.

I coauthored a piece in April called "Gambler's Blues: Betting Isn't Investing" that got more attention than almost anything I have ever written.

MarketWatch: If the market dropped 20% tomorrow, what should a retail investor do?

Sonders: There is no cookie-cutter answer for all investors, and that frustration I have with cookie-cutter answers is worth explaining. Imagine a little birdie from the future landed on my shoulder and whispered, with 98% probability, exactly what the stock market and bond market are going to do. I take that information and sit down with two investors.

Investor A is 25 years old. They inherited $10 million from their grandparents, go skydiving on weekends, are gainfully employed, and do not need the money right now. Investor B is 78, built a nest egg they cannot afford to lose, and is living off the income it generates. Even with near-certainty about where markets are headed, what I would tell those two investors is entirely different.

For some investors, a 20% drop is a buying opportunity. The financial media tends to say trim 15% of your equity holdings or hold a 60/30/10 portfolio (equities, fixed income and cash). But who is the investor? That context matters more than the market call.

'Valuation is often misunderstood. It is perfect to have in your knowledge bank, but valuation is a terrible market-timing tool.'Liz Ann Sonders

MarketWatch: Are investors paying a fair price for U.S. stocks at current valuations?

Sonders: We are not at egregious valuation levels right now. Valuations have improved, and for what is at least on the surface the right reason: earnings have surged. As of early August, you are looking at more than 50% earnings growth for the second quarter. When earnings grow faster than stock prices, valuations come down.

But here is the key point people miss: Valuation is a terrible market-timing tool. There is very little correlation between what any valuation metric reads at any point in time and what subsequent one-year market performance is.

I have scattergrams - charts showing no reliable pattern - of every major valuation metric against one-year forward returns, and the dots are all over the map. The correlation rounds to nearly zero.

If you extend to a 10-year horizon, then valuation connects to performance as you would expect. Lower starting valuations have historically produced higher long-term returns. But you really have to go to a 10-year-plus horizon for that relationship to hold.

MarketWatch: Are investors getting too excited about artificial-intelligence profits that may still be years away?

Sonders: The earnings growth from AI has been phenomenal. The risk right now is that the bar has been set so high that disappointment becomes possible even when results look strong. I have said for decades that better or worse often matters more than good or bad. That is a key tenet of how the stock market works.

The market focuses on inflection points, on when things stop getting better and start getting worse. The best stock-market performance historically comes in the early stages of an earnings recovery, when growth is barely back in positive territory. The worst performance comes in deep contractions.

'It is not what we know that matters. It is what we do that matters.'Liz Ann Sonders

MarketWatch: Is there a sector or theme that investors are overlooking right now?

Sonders: Energy still does not get a lot of attention, even though it is by far the best-performing sector this year. Part of the reason is that energy is a small share of the S&P 500 SPX. Even with incredibly strong performance, it does not move the cap-weighted index much. But we have increasingly been recommending investors consider an equal-weighted version of the index, because that is where you can find opportunity when leadership starts to shift away from the [market capitalization]-dominating sectors like technology.

MarketWatch: What is happening with the Federal Reserve that investors may be misunderstanding?

Sonders: Two things. First, there was a lot of worry in the transition from Powell to Warsh. I would hear questions like, what if Warsh just raises rates aggressively and goes against the committee? That is not how it works. There are 12 voting members. You need seven to agree on any rate decision. The chair has an important voice, but the actual decision is majority rule. The idea that any chair can simply impose their will is a misperception.

Second, people assume that rate hikes are automatically bad for stocks and rate cuts are automatically good. That is too simple. What matters is why the Fed is moving and how fast. If they are cutting because the economy has fallen into recession and deflation, that is very different from cutting because inflation has come down while the economy is still growing. The why and the pace both matter enormously.

At the time of this interview, the fed-funds futures market shows about a 30% probability of a rate hike at the next meeting. There is zero expectation of a cut. Inflation is still above the Fed's target. It has been above target for five years. There is no justification for a cut.

MarketWatch: People must ask you all the time what the market is going to do. What do you tell them?

Sonders: They do, and my answer is always the same: I do not know. Most strategists and analysts, most pontificators, should probably answer that way, because it is the truth.

The most important advice someone in my position can give is not to try to time the market short term, pick tops and bottoms, or make a call about when the next 10% correction is going to happen. That is pretty close to throwing a dart. It is not what we know that matters. It is what we do that matters.

The tried and true disciplines - diversification across and within asset classes and periodic rebalancing - do not make headlines. But that is what matters.

Michael Sincere is a freelance financial writer and researcher and the author of several books including "Understanding Stocks," "Understanding Options" and "Help Your Child Build Wealth."

-Michael Sincere