The tale of two markets continued in the second quarter. The S&P 500 returned 4%, driven by a 9% gain in the tech sector. Three stocks – Nvidia, Apple, and Microsoft – drove more than 90% of the market's growth during the quarter.
Meanwhile, seven of the remaining 10 sectors fell as concerns about slowing economic growth and higher-for-longer interest rates caused declines of 2% or more for the energy, basic materials, real estate, financials, and industrials sectors.
Many popular dividend strategies are overweight these areas of the market and underweight tech, where dividend payouts are sparser and artificial intelligence (AI) continues driving excitement about growth opportunities insulated from the broader economy.
The result was another quarter of subdued returns for dividend strategies relative to the tech-heavy market. Our portfolios returned between -2% and +1%, similar to the dividend funds below but better than the equal-weighted version of the S&P 500, which lost 3%:
Dividend Aristocrats ETF (NOBL): -5%
Schwab U.S. Dividend Equity ETF (SCHD): -4%
Vanguard High Dividend Yield ETF (VYM): -1%
Vanguard Dividend Appreciation ETF (VIG): 0%
This wasn't a new phenomenon. Excitement around AI has propelled a small group of big companies to drive the S&P 500's 15% rise this year. Nvidia, the designer of chips that accelerate AI by enabling fast data analysis, accounted for over 30% of the S&P 500's gains through June (and more than 40% of the index's return since the start of 2022). The firm even became the world's most valuable company for a few days before pulling back.
Tech behemoths Alphabet, Microsoft, Meta, and Amazon have accounted for another quarter of the market's gains in 2024.
These companies have seen higher demand for their cloud services (needed for AI computing) and used AI to power some of their own offerings, such as Amazon's shopping suggestions, Microsoft's Office 365 features, Alphabet's search results, and Meta's content personalization.
Following another strong quarter of performance, the four largest stocks in the S&P 500 now account for over 25% of the index's market value. The next two largest holdings – Amazon and Meta – make up another 6% of the S&P 500.
Source: Wall Street Journal
AI hype has quickly driven the S&P 500 to become the most concentrated it has ever been by some measures, with the top 10 companies exceeding 35% of the index.
Source: Apollo
The tech titans responsible for this surge are great businesses. They have pristine balance sheets, some of the fastest and most consistent earnings growth, and a front seat to AI-driven innovation that is just getting started.
Their valuations, while rich, aren't necessarily extreme since their profits have soared almost as fast as their stock prices.
Microsoft, Nvidia, Apple, Amazon, Meta, and Alphabet trade an average forward P/E ratio of about 34, which is less than 15% above the group's 5-year average multiple.
That's a lot higher than the S&P 500's P/E ratio near 21, but despite their huge size these businesses are expected to deliver average earnings growth of 24% in the year ahead (17% excluding Nvidia) – more than double the S&P 500's projected growth rate.
But can trees grow to the sky? Are we in an AI bubble fueled further by index fund inflows mindlessly bidding up the biggest stocks? Will the market's concentration lead to problems?
Few precedents exist to help answer these tough questions.
However, we can look back at two other periods of high concentration – the tech bubble of the late 1990s and the so-called "Nifty Fifty" stocks in the early 1970s, which kept the top 10 stocks in the S&P 500 weighted above 30%.
Each period had somewhat steeper valuations than today's environment.
The Nifty Fifty stocks had an average P/E ratio of 41.9 in 1972, more than double that of the S&P 500's 18.9. And at the height of the internet bubble in early 2000, Cisco peaked with a P/E ratio of over 200 as it became the world's most valuable company.
Neither era ended well for investors who chased the market's biggest winners near the top.
The graphic below shows that the S&P 500's future returns were much lower with market weighting compared to equal weighting. This is because the biggest companies underperformed the rest of the S&P 500 after investors' growth expectations proved too lofty.
Source: Silvercrest Asset Management
Maybe this period of unusual concentration in the market will end differently if AI lives up to the hype. But as a conservative income investor, I prioritize reliability over excitement.
Warren Buffett's wisdom shared in his 1996 shareholder letter remains just as relevant in today's AI era:
A fast-changing industry may offer the chance for huge wins, but it precludes the certainty we seek... Obviously many companies in high-tech businesses or embryonic industries will grow much faster in percentage terms than will "The Inevitables" (Coke, Gillette, etc). But I would rather be certain of a good result than hopeful of a great one...
Though some industries or lines of business exhibit characteristics that endow leaders with virtually insurmountable advantages, and that tend to establish survival of the fattest as almost a natural law, most do not. Thus, for every Inevitable, there are dozens of Imposters, companies now riding high but vulnerable to competitive attacks...
You can pay too much for even the best of businesses. Investors making purchases in an overheated market need to recognize that it may often take an extended period for the value of even an outstanding company to catch up with the price they paid...
Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher 5-20 years from now. Over time, you will find only a few companies that meet these standards – so when you see one that qualifies, you should buy a meaningful amount of stock.
While I prefer investing in companies with dominant positions in mundane industries – everything from trash collection to delivering electricity, providing insurance, and selling food and beverages – I understand the excitement about AI. The technology's potential use cases span virtually every industry and include:
Automating customer service chatbots
Personalizing shopping recommendations on e-commerce sites
Optimizing truck delivery routes
Taking fast food orders at the drive-thru
More accurately predicting when machine parts need to be replaced
Detecting financial fraud
Creating content
Enabling self-driving vehicles
But I can't begin to forecast all the ways – or not – that AI will cause technological upheaval as the market has increasingly priced in in.
By most measures, the revenue generated by AI applications remains relatively small today. The Wall Street Journal cited data showing that worldwide spending on generative AI solutions was under $25 billion last year, or the equivalent of about 5% of Apple's revenue.
But AI's growth potential and the fear of being left behind has driven massive spending to capitalize on this technological breakthrough, again dictated by just a small handful of big companies.
Microsoft, Amazon, Google, and Meta expect to increase their capital investments this year by nearly 50%, approaching $200 billion. They have the cash to do it and the support from investors, so this spending splurge looks set to continue for the foreseeable future.
Source: Sherwood
Most of this investment will be directed towards data centers, chips, and other equipment necessary to expand their cloud infrastructure, which is crucial for building, training, and deploying generative AI models for themselves and their customers.
As an outsider looking in, this type of frenzied spending makes me a little nervous. Whether these investments will earn a healthy return is anyone's guess and depends on how well AI applications are monetized in the years ahead.
Our dividend portfolios don't rely on AI to continue growing their income streams and preserving our capital over time.
I like owning businesses that solve timeless problems, generate predictable cash flow, and appear likely to become larger and more profitable as time marches on.
These companies aren't rocket ships, but they have their noses in a lot of important areas that can lead to upside when unexpected opportunity strikes.
By no skill of our own, a handful of our holdings have interesting exposure to (but not high dependence on) the AI buildout, including:
Dominion Energy (D): earns around 70% of its profits in Virginia, which is the largest data center market in the world. The electric utility expects to connect an additional 15 data centers in 2024 and notes these facilities have doubled or tripled in size versus historical norms. Dominion has worked with data center customers and regulators in its markets for many years and gained approval to expedite the process for key transmission projects that will help it meet rising power demand for these facilities.
Southern Company (SO): generates over 40% of its profits in Georgia, where its state utility sees retail electricity sales growing 9% through 2028 with 80% of the demand coming from data centers. The regulatory environments in Georgia and other key states like Alabama are among the most constructive in the US, providing confidence that the utility will find a profitable path to meet increased electricity demand in the years ahead.
Amphenol (APH): around 20% of Amphenol’s sales come from the IT and data communications market. This segment grew by nearly 30% last quarter, driven by accelerating demand for products used in power-hungry AI data centers. These facilities require higher efficiency types of power interconnect products to minimize the amount of electricity they consume while maintaining fast data transmission speeds. These are all areas Amphenol has specialized in for many years.
Oracle (ORCL): the cloud now accounts for over 30% of Oracle's revenue with over a third of that tied to infrastructure services rather than software. With more companies pouring money into training AI models, Oracle landed the largest sale deal in its history last quarter, reached a deal with ChatGPT maker OpenAI, and guided for double-digit revenue growth in the year ahead, which would be its fastest pace in more than a decade.
Parker-Hannifin (PH): the supplier of industrial motion and control technologies also provides solutions for liquid cooling in data centers, a market PH thinks will reach $2 billion by 2029 (for context, PH's revenue was $19 billion last year). The bigger opportunity might come from the semiconductor fabs that produce chips. PH sees the industry more than doubling in size by 2030, driving a need for more of the firm's climate control solutions, engineered materials, fluid and gas handling components, and process control systems.
Accenture (ACN): booked over $900 million in new generative AI projects last quarter. These are smaller projects for now since clients are mostly in experimentation mode, but Accenture's generative AI sales have topped $500 million year-to-date – more than the firm did in this category all of last year. If AI proves to be a game changer, more clients may need Accenture's services as they embark on large-scale transformations of their businesses.
If AI lives up to the hype, chances are that other holdings will find ways to use the technology to become more productive and innovative, driving faster earnings growth. Those are tough predictions to make, but time is the friend of great businesses that are always working to strengthen their positions.
For investors interested in more companies connected to the AI buildout, we created a value chain that highlights the most exposed dividend-paying stocks in each area, from the cloud computing providers down to the suppliers of data center components.
I put these companies into a spreadsheet you can download, too.
Source: Simply Safe Dividends
Looking ahead, our portfolios remain defensively positioned if AI hype moderates or the economy tips into a recession. The time-tested companies we own generally maintain strong balance sheets, produce steady cash flow, operate in markets with a slow pace of change, and trade at reasonable prices versus the broader market.
Our Top 20 and Conservative Retirees portfolios sport forward P/E ratios near 19, representing a moderate discount to their 5-year average multiples and the S&P 500's P/E ratio of 21.
Their earnings are expected to grow around 5% to 6% in the year ahead, too. While that's nowhere near as fast as the tech giants, which trade at an average P/E ratio nearly twice as high, I believe our growth is more reliable over the long run since we emphasize owning stable businesses like regulated utilities and food and beverage producers.
Our Long-Term Dividend Growth portfolio has a similar story, though it trades at a higher P/E ratio of 23. This reflects the portfolio's faster earnings growth, which is expected to be in the high single digits in the year ahead and support double-digit dividend growth over the long term.
I don't know when the broader market will stop being narrowly led by high P/E ratio stocks. But being a boring dividend investor means I don't have to make those tough calls.
I just need to tune out the noise, remain focused on keeping our income stream safe, and stay the course. The rest will eventually take care of itself as our portfolios steadily grow their earnings and dividends.
"Beware the investment activity that produces applause; yawns usually greet the great moves."
– Warren Buffett
Outside of our portfolios, we remain busy on the research front as more consumers grapple with a higher cost of living and elevated borrowing costs, causing strain in parts of the economy.
Recent comments from big-box retailers Walmart and Target, restaurants, lenders, branded food companies, appliance makers, apparel companies, RV dealers, and others have indicated that low- and middle-class households have become much choosier with their spending.
These anecdotes appear supported by the rising trend in missed payments on auto loans and credit cards. Gauges of consumer sentiment sit far below pre-pandemic levels, too.
Source: Bloomberg
Whether these cracks will become big enough to impact the broader economy or the Fed's patience to keep rate cuts on hold remains up for debate. But we are watching these factors and others closely as we continue assessing dividend safety across our coverage universe.
As always, we will be here if you have any questions or feedback for us to consider as we keep working to improve our website and research.
Thank you for your support of Simply Safe Dividends.
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