The Trouble with Counting Rate Hikes Before They Hatch

The S&P 500 gained 4.5% in December, bringing its fourth-quarter rally to 12% and finishing the year with a 26% return. The benchmark stock market index now hovers near its record high reached in early January 2022.

 

The Fed provided the spark last month after signaling expectations for three interest rate cuts in 2024, a notable pivot away from the “higher for longer” language that dominated rate discussions for most of the past year.

 

Fed official Thomas Barkin explained the shift in tone, stating, “Demand, employment, and inflation all surged but now seem to be on a path back toward normal.”

 

The Fed’s preferred measure of inflation, the personal consumption expenditures (PCE) price index, has steadily moderated over the past year. The core PCE inflation gauge advanced 3.2% in November from a year ago – not far above the Fed’s 2% target.

On a six-month annualized basis, PCE rose only 1.9%, the first reading in more than three years that sat below the Fed’s target, according to Bloomberg.

Proclaiming victory over inflation feels premature, but investors have rushed to price in rate cuts.

 

The 10-year Treasury yield had its biggest two-month fall since the financial crisis took hold in 2008, and junk bond yields plunged from 9.4% at the start of November to 7.3% at the end of December – their lowest level since August 2022.

 

The riskiest assets – especially those that depend on cheap money – soared the most.

For example, heavily indebted businesses like RV retailer Camping World and SL Green Realty, a Manhattan office REIT, rallied over 50% during the past two months.

Many growth stocks continued their resurgence as well, with the tech-heavy Nasdaq index finishing 2023 with a gain of more than 40%, its best year since 1999. (Lower rates make distant profits more valuable today.)

 

The Nasdaq now trades at a forward P/E ratio of about 25, roughly 30% higher than its 20-year average and not far below its multiple seen during the euphoric market conditions of 2020-21.

The tech sector accounts for about 29% of the S&P 500 (up from 20% when our portfolios debuted in 2015). Adding Amazon, Alphabet (Google), Meta, and Tesla, which reside in other sectors, brings that figure to roughly 40%.

Perhaps that weighting properly reflects technology's growing impact on everyday life. But tech’s elevated valuation multiple, hype around artificial intelligence despite uncertain profits, and rate-cut hopes create a high bar for recent returns to repeat.

 

Against this frenzied backdrop, defensive dividend stocks like utilities and consumer staples were left in the dust. But unlike the tech sector and tech-driven S&P 500, these cash cow sectors trade at forward P/E ratios that sit below their long-term averages.

This performance divergence reflects a reversal of 2022’s bear market themes. Defensive, dividend-focused areas of the market substantially trailed the market last year after buoying portfolios in 2022, while growth stocks that had taken a beating enjoyed a great resurgence.

 

Simply put, rising optimism for imminent rate cuts and a so-called soft landing – taming inflation while keeping the economy healthy – has renewed investors’ appetite for risk.

 

If you’ve invested for a long time, you probably know that these shifts in market sentiment provide little signal value and are often wrong.

 

At the start of 2023, many investors feared stocks and believed a recession was right around the corner. The year couldn’t have played out more differently.

 

Today’s growing calls for a soft landing are no guarantee either. Since World War II, the U.S. economy has achieved just one durable soft landing (in 1995) across more than 10 tightening cycles by the Fed.

 

Yet on the eve of recessions in 1990, 2001, and 2007, many economists expected such a feat as indicated by the number of ‘soft landing’ references made in Wall Street Journal articles.

Hopefully, this time is different. But long-term dividend investors don’t have to worry about making these difficult calls. And we are better off for that.

 

Instead of handwringing over the S&P 500’s large exposure to richly valued tech stocks or wondering if a hard landing looms, I stick to a simple plan – own quality businesses that generate consistent cash flow, maintain strong balance sheets, and treat shareholders well.

 
The end result is a growing income stream that can protect purchasing power against inflation and preserve capital over the long run.

Our model dividend portfolios have demonstrated these benefits since their inception in 2015, making it easier to tune out the market's noise.

Dividend cuts are the nemesis of this strategy and have ticked up.

Across the roughly 900 companies covered by our Dividend Safety Scores, we recorded 59 dividend cuts in 2023. That's up from 28 in 2022 and 17 in 2021 (see our complete track record here).

Should the economy slow further and interest rates remain elevated, another uptick in 2024 would not be surprising. And a full-blown recession could cause a wave of cuts (we logged over 300 cuts during the pandemic in 2020).

We can't predict when the next economic downturn will hit, so we don't try to. Our Dividend Safety Scores assess dividend risk over a full cycle, including the assumption of a moderate recession.

This approach promotes stable scores, even when the tide inevitably goes out, and aims to make managing a low-stress portfolio simpler for you.

As always, we'll continue to keep you updated on any new information that might affect the safety of your dividends and are eager to review the upcoming corporate earnings reports later this month.

Thank you for your support of Simply Safe Dividends, and please feel free to reach out if you ever have any questions or suggestions for us to consider as we improve the site.