AQN - A Massive Market Reversal Is Likely Coming

2023-11-15 08:05:00 ET

Summary

• Tech has flown high year-to-date, while several other sectors have been left in the dust.
• However, major economic trends are shifting, which we believe will lead to a massive market reversal in the coming days and weeks.
• We share how we are positioning our portfolio to profit from this anticipated market reversal, including a few of our top picks of the moment.

For the first 10 and a half months of 2023, the markets have experienced a massive bifurcation. Overall, it has been a very good year for the S&P 500 ( SPY )( VOO ), with the index up 18.64% year-to-date. However, underneath this strong performance is a tale of two segments:

1. AI-related tech companies - particularly the "Magnificent Seven" (i.e., Apple ( AAPL ), Nvidia ( NVDA ), Tesla ( TSLA ), Meta ( META ), Alphabet ( GOOG ) (GOOGL), Microsoft ( MSFT ), and Amazon ( AMZN )) - have flown higher, as evidenced by the extremely strong performance from the Nasdaq ( QQQ ), which is even more dominated by these names.
2. More defensive and interest rate-sensitive securities in the utilities ( XLU ), real estate ( VNQ ), and bond ( BND ) sectors have significantly underperformed. Moreover, smaller cap stocks ( IWM ) in general have significantly lagged behind the broader market as well.

Even dividend ETF investors ( SCHD )( VYM ) have suffered this year:

In this article, we will look at why this bifurcation has taken place and share why we believe that it is about to shift in a major way moving forward.

Why Defensive Dividend Stocks Have Underperformed In 2023

Dividend stocks, particularly Real Estate Investment Trusts (REITs), utilities, yield cos, and infrastructure businesses, have underperformed the S&P 500 this year primarily because of two major catalysts:

1. They are not expected to benefit from the artificial intelligence boom nearly to the same degree that technology stocks - especially the mega-cap tech stocks - are. As a result, a lot of equity capital left these more boring names in favor of piling into the more exciting cutting-edge technology stocks such as the aforementioned Magnificent Seven and AI stocks like Palantir ( PLTR ).
2. Interest rates have continued to rise and the surprising resilience of the economy and jobs market along with persistently hawkish verbiage from the Federal Reserve have shifted market expectations towards a higher for longer interest rate scenario.

Higher for long interest rates tend to hurt defensive dividend stocks for the following three main reasons:

1. When interest rates rise, defensive and contracted cash-flowing investments like REITs, utilities, yield cos, and existing fixed-rate long-dated bonds become less attractive, as investors can invest in newly issued bonds at higher relative yields, making existing income investments less appealing in comparison.

2. Many companies in sectors like utilities, real estate, and infrastructure rely on debt financing for their capital-intensive projects. When interest rates increase, their borrowing costs rise, which can negatively impact their profitability and, consequently, their stock prices as investors become wary of these companies' ability to generate returns in a higher interest rate environment.

3. In a rising interest rate environment, investors tend to become more risk-averse. While dividend stocks in sectors like REITs and utilities are generally viewed as defensive investments, the perception of their risk can rise due to concerns about rising interest expense and competition from higher-yielding fixed-income assets as well as cash-rich mega-cap stocks.

Why A Major Market Shift Is Coming

That being said, the market's outlook is in the process of shifting. Recent economic data indicates a slowdown is in the works, with inflation cooling significantly, job growth slowing, and consumer spending likely nearing its limits.

The Federal Reserve's preferred personal consumption expenditures price index reported a 3.44% inflation rate in September, reflecting a continued decline from its peak in July 2022. Moreover, the headline CPI number in October came in lower than expected at 3.24%, implying that the economy may be cooling even faster than was previously expected:

Moreover, the jobs market appears to be weakening. The recent U.S. jobs and wages data for October 2023 indicates that the job market may be weakening. For example, job growth slowed, with the 150,000 new jobs added falling short of expectations and marking a deceleration in employment gains. Meanwhile, the unemployment rate has also ticked up slightly to 3.9% while real wages have decreased by 5.8% compared to the previous year, signifying that wage growth is not keeping up with inflation.

Last, but not least, U.S. consumer sentiment fell for the fourth consecutive month in November as the University of Michigan's Consumer Sentiment Index dropped to its lowest level since May. Moreover, when combined with the recent depletion of excess savings accumulated by U.S. households during the COVID-19 pandemic and a significant rise in consumer credit card debt (now at a record level of over $1 trillion), it appears likely that there will be a meaningful decrease in consumer spending moving forward.

As a result of these factors, the Federal Reserve is very likely finished with hiking interest rates, and we expect that long and short-term interest rates are probably going to begin falling before too long. Moreover, the stock market will likely shift towards favoring more defensive stocks in the near future as the economy increasingly appears headed for a recession. This all points to a very bullish setup for defensive REITs, utilities, yield cos, and other businesses that have stable, contractual cash flows.

Investor Takeaway

While tech and broader index investors have had a great 2023 so far while dividend investors have generally been left behind, we believe that this is about to reverse in a big way as the market begins to shift its focus from higher for longer interest rates and the AI boom to falling interest rates and an impending recession. As a result, we expect the tech highflyers - including the Magnificent Seven - to materially underperform moving forward, while defensive REITs, utilities, yield cos, infrastructure companies, and other value-oriented dividend stocks outperform. As Billionaire "Bond King" Jeffrey Gundlach recently stated :

[The Magnificent Seven] will obviously be the worst performers in the upcoming recession. Whatever is leading the charge going into the economic downturn invariably must lead the charge on the way down. I would get out of them.

Instead, we are piling into investment grade, deeply undervalued, high-yielding names like Algonquin Power & Utilities ( AQN ), ATCO ( ACLLF ), Brookfield Renewable Partners ( BEP )( BEPC ), Brookfield Infrastructure Partners ( BIP )( BIPC ), Enterprise Products Partners ( EPD ), Energy Transfer ( ET ), Crown Castle Inc. ( CCI ), and Realty Income ( O ). Each of these businesses generates very defensive contractual cash flows that should hold up quite well during a recession, offers a high yield, has a solid investment grade balance sheet, should benefit from falling interest rates, and has meaningful valuation multiple expansion potential.

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