AIZN - Why I'm Convinced That SCHD Will Outperform

2023-03-10 13:16:43 ET

Summary

• In this article, we start with a discussion of a very tricky macro environment, consisting of a rapidly falling equity risk premium and growth challenges.
• While short-term bonds and cash have become attractive, there is a clear case to be made for dividend investments.
• SCHD is highly correlated to the best dividend stocks money can buy. The ETF has a high yield, consistent dividend growth, and a low expense ratio.
• While equity risks are high, I have little doubt that SCHD can outperform the market for many years to come.

Introduction

There is no alternative - until there is.

This article is dedicated to the transition from TINA (there is no alternative) to TARA (there are reasonable alternatives). In this case, we're talking about stocks and less-risky alternatives in cash and bonds. Thanks to an incredibly tricky macroeconomic environment and a Fed that continues to move dangerously close to a major policy error, we're in a situation where low-risk alternatives like bonds have reached favorable yields. Especially given the ongoing decline in economic growth and the related long-term risks, it makes sense for investors to re-consider their investment strategies.

Hence, in addition to discussing this macro environment, we'll dive into what works and what doesn't. I will give you some stock ideas and one major financial "tool" that gets the job done: the Schwab U.S. Dividend Equity ETF (SCHD) . Last month, we started discussing this ETF in light of a new macroeconomic environment. The theoretical discussion in this article is a perfect follow-up that re-enforces my outlook and expectations for SCHD.

So, let's get to it!

From TINA to TARA

Supported by ugly developments in (global) macroeconomic conditions.

One of the most interesting things about Seeking Alpha is the fantastic comment sections where people from all walks of life come together. Millionaires, starters with very limited capital, master traders, people sitting on huge losses, and so forth.

One major thing I noticed this year is that some people aren't buying stocks anymore. They now have better alternatives.

For example, the S&P 500 forward earnings yield (the inverse price/earnings ratio) has been in a decline since mid-2022. The yield on inflation-protected treasuries has been in a steady uptrend since then.

The higher the difference between the two, the more investors get paid to hold stocks. Right now, the equity risk premium has hit the lowest levels since 2009.

It also helps that equity alternatives come with much lower risks.

According to a recent report by Bloomberg , depositors who have been earning very low yields on their savings for years are starting to discover new options like Treasury bills and money market funds that offer higher yields as the Federal Reserve increases benchmark interest rates. This shift has led to a sharp drop in commercial bank deposits, with net withdrawals totaling $278 billion last year - the first time this has happened since 1948, according to Federal Deposit Insurance Corp. data.

In response to this trend, banks have started to raise their own rates, particularly on certificates of deposit (CDs), to prevent more outflows. Currently, over a dozen US lenders, including Capital One Financial Inc., are offering an annual percentage yield of 5% on CDs maturing in around a year - a rate that would have been unheard of just two years ago. Even the larger banks are starting to feel the pressure, with Wells Fargo & Co. now offering 4% on 11-month CDs.

Moreover, there are some good reasons to de-risk, if we consider that the Federal Reserve is aggressively hiking despite economic growth slowing. I discussed this in a just-released article , which I highly recommend.

One of the problems is sticky inflation, which requires the Fed to maintain a hawkish stance. Markets are now pricing in three more rate hikes. One 50 basis points hike in March, followed by two 25 basis points hikes. The current terminal rate is expected to be 5.75%.

The implied probability of a >5.00% interest rate at the end of this year is now close to 100%. That number was 0% earlier this year.

Hence, we now have a situation where short-term rates are rising to price in more hikes. Meanwhile, longer-term yields aren't rising as much, as investors are betting on more weakness down the road. Who can blame them? After all, the Fed has a track record of breaking something (Bank of America's words, not mine) whenever it is forced to aggressively hike rates.

Hence, the yield curve hasn't been this inverted since the 1980s, which indicates a high recession probability. The probability is even higher than it was prior to the Great Financial Crisis. This doesn't mean the (potential) upcoming recession will be worse, but it means that the Fed is on thin ice. Inflation needs to come down quickly.

Based on this context, investors are shifting their money.

Investors Are De-Risking

However, it's different from what one might expect.

According to the latest FundFlows report from Refinitiv Lipper (via Seeking Alpha ), investors were mostly buying funds during the week that ended on March 2, 2023. This includes both conventional funds and ETFs, and the total net purchases amounted to $38.8 billion.

Money market funds have been particularly popular among investors, with inflows recorded for the third consecutive week, totaling $55.0 billion. However, other types of funds did not fare as well. Equity funds saw outflows of $13.5 billion, while taxable bond funds experienced outflows of $1.7 billion. Tax-exempt bond funds were also not immune to outflows, reporting a decrease of $905 million.

In other words, investors are buying "cash". That's no surprise as short-term bonds have become very attractive - although still dependent on the trajectory of the expected hiking cycle.

For example, the SPDR Bloomberg 1-3 Month T-Bill ETF ( BIL ) has a 30-day SEC yield of 4.4%.

If we ignore the core differences between bonds and stocks, we're dealing with a high yield with much lower risks.

The other day, a sell-side firm used an example of a very wealthy "boomer" who had $10 million in his account. By buying 5%-yielding 2-year bonds, he would make $500K per year with limited risk. Given that the average "boomer" age is 68, that's a terrific deal.

While this is a perfectly reasonable assumption, there are other alternatives. Investors aren't just buying bonds, they are also buying high-quality stocks, which is exactly what we have been doing since 2020.

The Wall Street Journal just came out with an article making the case that investors are getting into dividend-paying stocks, using the same Refinitiv Lipper report I highlighted in this article as well.

According to the WSJ :

Although higher rates would likely be punishing for the market as a whole, dividend-paying stocks would see another chance to shine. Shares of companies paying big dividends outperformed the broader market last year when red-hot inflation, higher rates and worries about an impending recession weighed on risk assets.

The S&P 500 High Dividend Index-made up of the S&P 500's top 80 dividend-paying companies-fell 1.1% including dividends last year, compared with a negative total return of 18% for the broad benchmark. In 2023, the index is up 1.9% but is trailing the S&P 500's 3.7% advance.

Many financial experts believe that the United States is not on the brink of a recession. However, given the current state of economic, market, and geopolitical affairs, dividend-paying stocks are considered a smart defensive investment.

Investors who are concerned about the possibility of a recession caused by continued interest rate increases and sticky inflation can still find safety in income-generating stocks. Analysts at UBS Group AG have recommended such stocks as a safe harbor for investors seeking stability and security in uncertain times.

Moreover, and according to a recent note highlighted by the WSJ, analysts are forecasting a 1% increase in the S&P 500's dividends per share this year, despite a potential 11% drop in per-share earnings in a recessionary environment. Investing in dividend-paying stocks now also comes with an added bonus: many of these stocks are currently trading at a 15% to 20% valuation discount relative to the market, making them attractive bargains that provide a reliable source of cash flow.

Over the past two years, high-dividend yield stocks have returned 12.2%. The S&P 500 has returned 4.2%. Also, note that dividend stocks have gone sideways since early 2022 - the market has gone down since then.

Moreover, my belief is that dividend stocks can benefit from ongoing long-term repositioning. Since the Great Financial Crisis caused rates to drop to zero, investors have been buying growth stocks for more than a decade. While 2021 and 2022 caused a shift, I believe this shift will continue, as investors are starting to figure out that we're likely in a new economic environment.

As I wrote in my most recent article on SCHD, we might be in a new era.

I believe that we're in a new long-term environment of above-average inflation, caused by secular changes like labor market dynamics, energy and commodity supply growth, and de-globalization (changing supply chains).

In that article, I quoted legendary investor Howard Marks' latest memo , which highlighted and compared major differences between now and the highly favorable period for stocks between 2009 and 2021.

This is the part that stood out:

- While some recent inflation readings have been encouraging in this regard, the labor market is still very tight, wages are rising, and the economy is growing strongly.

- Globalization is slowing or reversing. If this trend continues, we will lose its significant deflationary influence. (Importantly, consumer durables prices declined by 40% over the years 1995-2020, no doubt thanks to less-expensive imports. I estimate that this took 0.6% per year off the rate of inflation.)

- Before declaring victory on inflation, the Fed will need to be convinced not only that inflation has settled near the 2% target, but also that inflationary psychology has been extinguished. To accomplish this, the Fed will likely want to see a positive real fed funds rate - at present, it's minus 2.2%.

- The Fed faces the question of what to do about its balance sheet, which grew from $4 trillion to almost $9 trillion due to its purchases of bonds. Allowing its holdings of bonds to mature and roll off (or, somewhat less likely, make sales) would withdraw significant liquidity from the economy, restricting growth.

With that said, one of the easiest and best ways to play this major shift in macroeconomic developments is the SCHD ETF.

Reasons To Go With The SCHD ETF

A great ETF that comes with macroeconomic tailwinds.

The SCHD ETF has gotten a ton of attention lately. However, I believe the biggest tailwind is still under-reported.

As we just discussed, there is a longer-term thesis that favors high-quality dividend stocks.

Unfortunately, it's not that easy. Picking the right stocks is the tricky part. I discussed this in a recent diversification-focused article as well.

Interestingly enough, the other day, I found an old file on my computer, discussing the impact of rising real yields on stocks, which is now more valid than ever. I'm bringing this up because not all stocks do well in this environment.

• The relationship between real rates and stock prices: Higher real rates can also lead to lower stock prices . This is because higher interest rates increase the discount rate used to value future cash flows. This can lead to lower stock valuations, which can negatively impact dividend investors.
• Strategies for investing in a rising real rate environment: One strategy is to focus on companies with strong balance sheets and low debt levels . These companies are less likely to reduce their dividend payments in response to rising rates. Another strategy is to diversify across sectors and asset classes to reduce overall portfolio risk.

The best stocks in this environment are companies with strong balance sheets, low debt levels, and (related) safe dividends.

For example, the list of stocks below was generated using the Yahoo Finance Screener based on the following filters:

• Companies based in the United States
• Only large- and mega-cap companies.
• A net leverage ratio of no more than 2.0x EBITDA.
• A dividend yield of at least 2%
• At least 15 years of consecutive dividend growth.

1. Exxon Mobil ( XOM )
2. Johnson & Johnson ( JNJ )
3. Procter & Gamble ( PG )
4. Chevron ( CVX )
5. Texas Instruments ( TXN )
6. Qualcomm ( QCOM )
7. Lockheed Martin ( LMT )
8. Automatic Data Processing ( ADP )
9. Illinois Tool Works ( ITW )
10. Air Products & Chemicals ( APD )
11. Colgate-Palmolive ( CL )
12. 3M Company ( MMM )
13. Emerson Electric ( EMR )
14. Archer-Daniels-Midland ( ADM )
15. The Travelers Companies ( TRV )
16. Aflac Incorporated ( AFL )
17. Cummins ( CMI )
18. Genuine Parts ( GPC )
19. Hormel Foods ( HRL )
20. Robert Half International ( RHI )
21. Williams-Sonoma ( WSM )
22. Polaris ( PII )
23. Assurant ( AIZ )
24. Flowers Foods ( FLO )

When put in an equal-weight portfolio, these 24 stocks (portfolio 1) have returned 13.8% per year since 2012. The standard deviation was 14.2%.

That's a terrific return.

However, you could have gotten a 13.2% return with a 13.8% standard deviation without having to monitor 24 individual stocks.

The SCHD ETF has moved in lockstep with these 24 investments, generating an almost equal return.

In other words, SCHD turned out to be a terrific proxy to invest in the safest, most reliable dividend stocks on the market. This ETF holds 105 companies with a weighted average market cap of $127 billion. Its 30-day SEC yield is 3.4%.

In its top 10, it holds a number of stocks that were also listed above.

Even better, this 3.4% yield comes with high historical dividend growth. While I expect dividend growth to come down in 2023 and likely beyond, this ETF had growth rates that even beat a wide range of dividend-growth stocks.

Moreover, the ETF has an expense ratio of just 0.06%, thanks to its passive approach. The ETF tracks the Dow Jones U.S. Dividend 100 Index, which allows Schwab to keep the expense ratio low.

Over the past three years, SCHD has outperformed the S&P 500 by more than 17 points. It even outperformed dividend growth stocks, which failed to beat the market - at least when using the Vanguard Dividend Appreciation ETF ( VIG ) as a proxy.

Needless to say, as we discussed in this article, dividend stocks can suffer too. They are riskier than money market funds. However, SCHD comes with a good yield, satisfying long-term dividend growth, and a massive tailwind that should allow investors to outperform the market.

Takeaway

In this article, we did two important things.

First, we started with a discussion that outlines the tricky macroeconomic environment we're in. For the first time in many years, there is a low-risk alternative for stocks. When adding declining economic growth and a Fed eager to hike into weakness, we get a scenario that warrants a move to safety.

While bonds are the safest option, high-quality dividend stocks also offer safety. Hence, I presented the SCHD ETF. This ETF is highly correlated to the best/safest dividend stocks money can buy. It has a low expense ratio, a good yield, consistent dividend growth, and a high likelihood of outperforming the market on a prolonged basis.

While the market is extremely volatile again, I sleep well knowing I have 90% of my net worth in dividend stocks.

That said, do you agree with me? What's your strategy and view on the market? Let us know in the comment section!

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