The S&P 500 had its strongest start in five years, rising 10% in the first quarter. Meta and Nvidia drove more than a third of the S&P 500's year-to-date gain, according to the Wall Street Journal, helping the index extend its climb since late October to nearly 30%.
A rally this strong, this fast can feel troubling to risk-averse investors. We are supposed to be fearful when others are greedy, right?
Well, that's not quite how history has always played out.
Over the last 50 years, whenever the S&P 500 experienced a surge of at least 25% within a 100-day timeframe (as it has recently), the index, on average, climbed an additional 15% in the following year. And it was positive overall 98% of the time, according to JPMorgan.
Source: JPMorgan Wealth Management
I didn't expect that. But the chart above provides a powerful reminder to prioritize time in the market over timing the market. If you've been investing for long enough, you know how easy it can be to outsmart ourselves.
That said, this rally has felt uncomfortable since stock prices have increased much faster than underlying profits.
Since October, the S&P 500's forward price-to-earnings (P/E) ratio (red line below) has expanded from about 17 to 21, well above its long-term norm thanks to the tech sector's swelling valuation multiple (blue line below).
Tech stocks (including Alphabet, Amazon, and Meta, which technically reside in other sectors) now account for about 40% of the index, up from 20% less than a decade ago.
Source: Yardeni Research
Investors' enthusiasm feels even more surprising with inflation showing some stickiness. The Fed's preferred inflation measure didn't improve much in January and February and remains almost a full percentage point above the 2% level that policymakers target. Meanwhile, economic growth has fared better than expected, the jobs market has remained strong, U.S. manufacturing activity recently expanded for the first time since September 2022, oil prices have jumped 20% this year, and buoyant financial markets have propelled U.S. household wealth to a new record.
Along with the substantial federal budget deficit (i.e. government spending exceeds revenues), which further supports the economy, these indicators suggest the battle to fully tame inflation isn't over and could further delay interest rate cuts.
"The fact that the U.S. economy is growing at such a solid pace, the fact that the labor market is still very, very strong, gives us the chance to just be a little more confident about inflation coming down before we take the important step of cutting rates."
– Fed Chair Jerome Powell, 3/29/24
The higher-for-longer interest rate narrative remains in play, and some investors believe we now might not see any Fed rate cuts this year.
This helps explain recent movements in the 10-year Treasury yield, which fluctuates with inflation and economic growth expectations and has increased from 3.9% to 4.3% this year.
Rising yields have continued to drag on the performance of bond-like dividend stocks and companies with rate-sensitive businesses.
The utility sector gained only 4% in the first quarter, and real estate investment trusts lost 1%. The defensive, slower-growing consumer staples sector also trailed the S&P 500 with a return of 7%.
Consumer discretionary stocks were another sore spot, rising just 3%. High rates have frozen activity in the housing market and raised borrowing costs. Delinquency rates on credit cards and auto loans spiked to their highest since the 2008-09 financial crisis. Inflation has also led consumers to pull back on non-essential purchases such as apparel.
Outside of some strength in the value-oriented financials and energy sectors this quarter, it's been another tough stretch for high dividend investors.
The chart below from S&P Global shows returns over the past year for various subgroups of S&P 500 stocks. High dividend and low volatility strategies have taken a far back seat to momentum and growth strategies, which have driven the S&P 500 higher by about 30% over this period.
Source: S&P Global
Small-cap companies, represented by the Russell 2000 index, have missed a lot of the party as well, returning 5% in the first quarter and under 30% since the start of 2020 – less than half the S&P 500's return.
Many popular dividend stocks are smaller in size. For example, nearly half of the Dividend Kings – companies with at least 50 consecutive years of payout raises – have market caps below $10 billion (S&P 500 companies have a median market cap of $35 billion).
Smaller businesses are more sensitive to rates since 40% of debt on Russell 2000 balance sheets is short-term or floating rate, compared with about 9% for S&P companies, according to the Financial Times.
This has led to a historic performance divergence between small and large companies:
"US small-cap stocks are suffering their worst run of performance relative to large companies in more than 20 years, highlighting the extent to which investors have chased megacap technology stocks while smaller groups are weighed down by high interest rates."
– The Financial Times, 3/27/24
The bottom line is that many dividend investing strategies have had an unusally tough run compared to the S&P 500 over the last couple of years due to a confluence of factors ranging from interest rates and artificial intelligence to a rotation into mega-cap growth stocks.
While I am a believer in mean reversion over the long run, your guess is as good as mine regarding what happens next. The complex nature of the economy and stock market makes forecasts notoriously difficult.
For example, the blue and red lines in the chart below show where the market thought U.S. rates would head at different points in time dating back to 2008. The white line shows where rates actually went.
The market often overestimates or underestimates the path of interest rates. Following the 2008-09 financial crisis, markets continued to think rates would get back to their pre-crisis levels, but this didn't play out until the pandemic unleashed a wave of inflation.
Source: EEAGLI
As we look ahead, it's a bit unsettling to wonder if interest rates will stay much higher than the market expects and create stress somewhere in the system, or if the Fed will slowly soften its inflation target to tolerate a somewhat higher level.
I'm reminded of a 1981 hit released by one of my favorite rock artists, the late Tom Petty, who sang the catchy chorus, "The waiting is the hardest part." Petty explained this song was "about waiting for your dreams and not knowing if they will come true."
Investors who are retiring and trying to figure out a safe withdrawal rate might feel that way if their plans center on owning the increasingly tech-heavy, richly-valued, and concentrated stock market index (the five largest holdings now make up 25% to 30% of the S&P 500 and Nasdaq).
Dividend investors don't need to worry as much. Our goal is to build a portfolio of quality companies and funds that can pay us a rising passive income stream into perpetuity.
That means looking for businesses with timeless products and services, predictable cash flows, strong balance sheets, and track records of treating their shareholders well – not making macro forecasts or banking on a certain level of return from the market.
I've shared this chart before, but it's the perfect picture of what we are trying to accomplish for conservative investors in retirement. Johnson & Johnson's (JNJ) stock price is plotted in blue next to the healthcare giant's quarterly dividends per share in orange. Dividends provide regular income regardless of what the market is doing. Investors who can live off dividends don't need to worry about selling shares to make ends meet. This provides peace of mind when the tide goes out.
J&J's share price slumped 40% during the 2008-09 financial crisis. The company's dividends kept increasing during this period, along with others where J&J's stock stagnated for several years or faced major shocks like the pandemic.
Unlike most fixed income securities, Johnson & Johnson's dividends have also steadily grown, exceeding the rate of inflation to protect a retiree's purchasing power. And as the company's profits increased over time, J&J's share price followed higher.
Building a portfolio that yields around 4% and has mid-single-digit annual dividend growth potential is very achievable in today's market environment and allows an investor to tune out the noise – including the growing temptation to chase yesterday's momentum stocks.
As always, we will be here every step of the way with research and improvements to our website's capabilities to help you keep your portfolio between the guardrails.
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.
