QQQ - Massive Market Upheaval Likely Ahead: Buy Stocks With These 4 Traits
2024-01-16 11:30:37 ET
Summary
- The markets have undergone significant bifurcation over the past year.
- Peter Lynch and similar legendary investors have pointed out that significant opportunities have emerged as a result.
- We believe that a major macroeconomic shift will lead to an even larger market change in the coming months.
- We share the four traits that we are looking for in stocks as we look ahead to this coming market upheaval.
2023 was dominated by the higher rates for longer narrative and artificial intelligence hype. As a result, bonds ( BND ), preferreds ( PFFA ), and high-yield stocks ( DIV ) struggled for the first ten months of the year:
Meanwhile, AI-focused names such as the "magnificent seven" (Apple ( AAPL ), Meta ( META ), Amazon ( AMZN ), Alphabet ( GOOG )( GOOGL ), Tesla ( TSLA ), NVIDIA ( NVDA ), and Microsoft ( MSFT )) boomed:
What this sharp bifurcation in markets produced was a premium valuation of the magnificent seven-dominated S&P 500 ( SPY ), while many quality dividend stocks - especially in the interest rate sensitive small-cap ( IWM ), REIT ( VNQ ) and utility ( XLU ) sectors - were suddenly deeply undervalued. Even legendary investor Peter Lynch noticed this sharp bifurcation and called it out as an intriguing investment opportunity to take advantage of.
Since then, concerns about higher-for-longer interest rates have ebbed somewhat, causing a sharp recovery among dividend stocks, though utilities in particular have continued to lag SPY's performance:
In this article, we will discuss why we think that this is all about to change, leading to substantial market upheaval, and then share four key traits that we are looking for in stocks that are likely to outperform in the period ahead.
Why Massive Market Upheaval Is Likely Ahead
We think that roles are likely going to be sharply reversed in the near future, with tech ( QQQ ) likely underperforming high-yielding stocks.
Historically, dividend stocks have generated higher returns over the long term compared to non-dividend-paying stocks. This is largely because stocks that pay dividends consistently over time generally are forced to exercise much greater capital discipline and only invest in the highest-returning growth projects. Moreover, stocks that pay dividends typically have sustainably profitable business models. As a result, we do not expect this to change and continue to believe that dividend stocks will continue to outperform non-dividend payers over the long term.
Moreover, it is important to keep in mind that the recent underperformance of dividend stocks was not driven by fundamentals but by the preference of income-focused investors, as they sold dividend stocks in favor of alternative income sources due to their expectation that interest rates would remain higher for longer.
Third, the fact that growth stocks are currently overvalued relative to interest rates indicates that their risk-reward profile is unattractive right now. In contrast, many dividend stocks, even after a recent rally, are still down substantially from their highs and their valuations continue to be steeply discounted compared to their historical averages. As a result, they provide investors with very attractive risk-reward profiles.
Last, but not least, we still believe that a recession is likely. Historical patterns indicate that soft landings are rare, with the majority of past Fed-rate-hike cycles leading to recessions. Moreover, the current economic scenario differs significantly from previous soft-landing periods, with higher inflation, tight lending standards, and increased financial burdens on consumers placing significant strain on the economy. Additionally, the brisk pace of Fed tightening and their hesitancy thus far to meaningfully back off from their tighter monetary policy further strengthens our conviction that a recession is the most probable outcome over the next six months.
As a result, we believe that the Fed will ultimately be forced to slash rates meaningfully in the coming quarters in an effort to prop up the economy ahead of the 2024 election. As interest rates decline, we expect that capital will flow back into dividend stocks, especially ones with defensive business models, potentially causing them to soar as they close the gap to their historical valuation averages relative to tech stocks.
Buy Stocks With These Four Traits
With that being said, unless you plan on buying quality low-cost, and well-diversified dividend ETFs like the Schwab U.S. Dividend Equity ETF ( SCHD ), we do not advocate for blindly buying any dividend stocks. Instead, we think it is prudent to focus on stocks that will provide a resilient and predictable income stream through good times and bad and therefore exhibit the following four traits:
- Defensive models
- Strong balance sheets
- Safe and growing dividends
- Sufficiently high current yield/Attractive valuation
Companies in sectors like utilities, consumer staples, real estate, and healthcare often exhibit resilience against economic volatility and technological disruptions, providing stable cash flows for reliable dividend payments. With these sorts of companies, you can typically sleep well at night knowing that - barring imprudent financial management - your stock is not going to zero and the dividend should remain stable - if not growing - over the long term.
This brings us to our second trait: a strong balance sheet is so important because it ensures that companies can avoid financial distress that often leads to dividend cuts during economic/industry downturns.
Third, a safe and growing dividend payout is also essential, because dividend cuts often l ead to significant underperformance in the stock, and stocks that grow their dividends over time almost always enjoy significant stock price appreciation over time as well.
Last, but not least, investing in stocks that offer substantial starting yields and attractive valuations is also obviously important because they provide investors with a wide margin of safety that can help to hedge against adverse macroeconomic and company-level outcomes such as:
- Interest rates ending up remaining higher than you may have previously expected
- A severe recession or sector-specific downturn suppressing earnings growth
- Management making disappointing capital allocation decisions and/or growth investments not panning out as well as you previously expected
Investor Takeaway
Given that we see dividend stocks as being much more opportunistically priced than technology stocks and we also expect shifting macroeconomic and interest rate conditions to be a major catalyst, we expect a significant market upheaval to take place in the coming months, with tech dropping from market leader to market laggard and dividend stocks soaring from laggard to leaders.
By focusing on stocks with durable and defensive businesses, robust balance sheets, safe and growing dividend payouts, and attractive yields and valuations, investors position themselves to likely win big in the event that this scenario manifests itself while still not losing much, if at all if macro conditions do not align for dividend investors in the near term.
Some stocks that we feel meet these four conditions particularly well right now are Enterprise Products Partners ( EPD ), Energy Transfer ( ET ), and ATCO ( OTCPK:ACLLF ).
For further details see:
Massive Market Upheaval Likely Ahead: Buy Stocks With These 4 Traits