The Drawback of Money Market Funds as Uncertainty Rises

The S&P 500 lost ground for a third straight month, dipping 2.2% in October to narrow its year-to-date return to about 10%. The stock market has now lost roughly 10% since mid-July as investors worry about rising interest rates and a potential economic slowdown.

 

You wouldn’t know that from the latest economic data. U.S. GDP expanded at an annualized rate of 4.9% during the third quarter. The U.S. unemployment rate hovers near a multidecade low at 3.8%. And consumer spending rose more than expected in September.

 

But many companies see a less certain future. With corporate earnings season just over halfway finished, Bloomberg noted that “weak demand” is among the top trending phrases on earnings calls. If the pace of mentions holds for the next few weeks, it would be the most on record going back to at least 2000.

Across the hundreds of dividend stocks we monitor, storm clouds keep forming over certain sub-sectors. Regional banks continue getting squeezed by higher deposit costs. Spending on discretionary goods like apparel and toys has fallen as inflation squeezes wallets. Freight demand is weak. High mortgage rates have frozen the housing market and reduced demand for new appliances, mattresses, furniture, paint, and flooring.

 

Throw in additional headwinds from higher borrowing costs and the selloff in bond-like stocks as interest rates have sharply increased, and the underperformance of dividend strategies over the past year doesn’t come as a big surprise.

 

Some risk-averse investors have responded by hiding out in cash. Why take on the risk of capital loss by holding stocks when money-market funds now pay over 5%? Holdings of money-market funds have nearly doubled since before the pandemic. But unless your time horizon is short, making a dramatic asset allocation shift like this makes little sense.

 

Take Vanguard’s money-market fund as an example. Since its 1981 inception, when double-digit rates prevailed, the Vanguard fund has returned 3.9% annually, or a cumulative 402%. The S&P 500 has returned nearly 11% a year and about 3,500% through the same period. And a bond index sits almost in the middle, per the Wall Street Journal.

Your investment horizon might not span 40-plus years. But even with a 15-year window, the S&P 500’s average annual return is around 9%, with practically every rolling 15-year period throughout history showing a positive return (and most exceeding 5% per year).

Stock ownership has historically been one of the best and easiest ways to grow capital and protect against inflation over time. And compared to money-market funds, investing in equities can be done with minimal to no fees and more favorable tax treatment.

 

Owning a diversified portfolio of quality dividend stocks provides all these benefits but with added peace of mind. Great businesses capable of paying safe dividends over a full economic cycle tend to generate consistent cash flow, maintain healthy balance sheets, and have durable competitive advantages that drive long-term earnings growth.

 

These companies can weather most storms, from war in the Middle East to bond market selloffs and economic contractions. A portfolio holding a diversified mix of these stalwarts will see its market value swing, perhaps significantly, any given year. But the dividends generated should march higher regardless, eventually pulling share prices up with them.

 

That consistently rising income stream is something a money-market fund can never guarantee. In each of the five recessions dating back to the early 1980s, the Fed’s benchmark federal funds rate has been at least cut in half or taken to zero percent.

 

With the Fed earlier this week choosing to hold its rate at a 22-year high of 5.25% to 5.5% for the second consecutive meeting, short-term interest rates could finally be peaking after an 18-month hiking campaign intended to cool inflation. The next move, whenever it happens, could be down. But our portfolios’ dividend income will very likely be higher.

 

I don’t try to predict where interest rates will go from here. But if it turns out we are at the end of the Fed’s rate rise cycle, or an event happens that triggers a sharp drop in money-market fund yields, some of the cash parked there could quickly rotate back into longer-dated bonds and higher-yielding dividend stocks that have been beaten up.

 

Fortunately, we don’t need to rely on “lucky” asset class rotations to achieve our goals of safe income growth and long-term capital preservation. Such short-term thinking should never serve as an investment strategy’s foundation.

 

Instead, knowing what you own and why you own it is the best medicine for staying the course and being prepared for whatever comes next. We are always here to help you in this journey and take your trust in us seriously.

 

Behind the scenes, this is the busiest we have been pouring through companies’ earnings reports since the onset of the pandemic, when we worked around the clock to keep our members informed during a very dynamic time. As we alluded to earlier, many “old economy” businesses face recessionary-like operating conditions as inflation headwinds and tighter financial conditions build.

 

This inspired us last month to share research on the debt profiles of over 250 popular dividend stocks, including a look at each firm’s use of variable-rate debt and their looming maturities. And we are turning over many stones as new information emerges to keep you on top of what matters most about your holdings, including the safety of their dividends.

 

We won’t get every call right. But we will always operate with integrity and work our hardest to help you keep your dividend portfolio between the guardrails.

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