Tune Out the Interest-Rate Noise and Find Costco's

The S&P 500 returned 5.8% in the third quarter, stretching its year-to-date gain to 22% (and a whopping 36% over the past year). But the latest jump in stocks felt different. This time, dividend stocks, not AI hype, led the way.

The tech sector dipped 1% while rate-sensitive utilities and real estate investment trusts (REITs) surged around 20%. No doubt the Fed's decision to kick off its rate-cutting cycle in September with a larger, half-point reduction played a role (more on that later).

Falling rates and growing hopes for a soft landing also boosted investor sentiment across cyclical sectors like industrials, materials, consumer discretionary, and financials. Each of these areas gained around 10%.

As luck would have it, this welcome reversal came right after we noted in our July newsletter that a small handful of tech giants had driven most of the S&P 500's recent gains, leaving many quality dividend stocks in the dust and looking attractively valued.

You never know when the market's mood will shift. It's not something we spend any time trying to predict. But as Ernest Hemingway once penned, change can happen gradually, then suddenly.

The eight Income Ideas we shared last quarter highlight this phenomenon.

Since their publication on July 5 through September 30, each of these stock and fund ideas trounced the S&P 500's total return of 3%, with all but one also outpacing the 11% return posted by SCHD, Schwab's popular dividend ETF.

There was nothing particularly special about these ideas. No disruptive tech (the youngest company on the list was founded in 1971) or big growth stories. Just time-tested businesses that looked a little unloved despite their stable long-term outlooks.

Our new Valuation tool makes these potential opportunities a little easier to spot. Using our McDonald's pick as an example, the chart below plots an Expected Price band showing what shares would be worth if they traded within 10% of their 5-year average P/E ratio.

McDonald's stock traded below this range over the summer as investors worried about inflation-pinched consumers spending less on fast food. We didn't think these concerns had any bearing on McDonald's long-term outlook, and the stock quickly rebounded to its usual valuation range.

I can almost promise you this quarter's Income Ideas will not work out so well, so quickly. I chalk up the gains above to lucky timing more than anything else.

If you've followed us for long, you know that we never try to guess which stocks will do well next quarter or even next year. That's speculating, not investing.

Prices can disconnect from fundamentals for a long time – longer than you can stay solvent, as economist John Maynard Keynes famously stated about the market. But, eventually, the valuation of a business will converge with its underlying performance.

Instead of worrying about when that might occur, we simply look for great businesses with safe dividends, durable competitive advantages, strong financial health, opportunities to grow their profits over the next decade, and reasonable or better valuations.

When we find a company that checks these boxes and continues to do so, increasing its intrinsic value over time, we hope to hold it forever – regardless of near-term price performance. That strategy has limited our model portfolios to an average of 1-2 trades per year over the past decade while delivering rising dividends every year and healthy capital appreciation.

Unfortunately, many market pundits and newsletter services thrive by urging you to take action with your portfolio, not remain idle.

A lot of the latest noise I've seen centers around interest rates. You guessed it – we are not adjusting our portfolios in anticipation of where rates could head and which types of investments could benefit the most. It's just not that simple or predictable.

The Fed kicked off its 23rd rate-cutting cycle since 1928 when it reduced its benchmark interest rate by 0.5% in September. The yellow dots below mark the 22 previous times the Fed started lowering rates to try and support economic growth and avoid a recession, which is indicated by the grey bars.

The Fed's job is tough. In over half of the instances when it first cut rates, a recession either happened at the same time or soon after. This includes the last three easing cycles, which ended with the 2020 pandemic, the 2008 financial crisis, and the 2000 dotcom bubble.

These coin flips are anyone's guess. The only conclusion I'm comfortable offering, though not very satisfying, is that the market's short-term performance and the best-performing stocks mostly depend on how the economy does.

JPMorgan looked at each rate cut cycle since 1965, splitting the market's performance out by whether the economy entered a recession or pulled off a soft landing. Good news on the economy is usually good news for stocks, with soft landings historically delivering an average return near 15% in the year following the Fed's initial rate cut.

When rates come down gradually – a scenario typically associated with a soft landing – stocks with faster dividend growth rates have historically outperformed in the months after the first cut, according to a study by Ned Davis Research.

Some companies that we think fit this mold today include paint maker Sherwin Williams (SHW), roofing and insulation leader Carlisle (CSL), payment networks Visa (V) and Mastercard (MA), and payroll processor and HR software and services provider ADP (ADP).

But when the economy shrinks and takes rates sharply lower, higher-yielding stocks in defensive sectors like utilities, healthcare, and consumer staples have done better. Potential examples include utility company WEC Energy (WEC), snack and beverage giant PepsiCo (PEP), and agricultural processor Archer Daniels Midland (ADM).

Please don't get hung up on this, though. While many analysts enjoy chattering about what could happen next month or next year, that mindset risks missing the forest for the trees.

Since 1970, the S&P 500 has always been up five years after the Fed's initial rate cut. Recessions and drawdowns in the stock market matter very little over longer time horizons despite the emotional urge they can create to shake up your portfolio or sell your investments.

The late legendary investor Charlie Munger made some relevant comments at a 2019 shareholder meeting for Daily Journal, a newspaper publisher he led as Chairman of the board. An audience member asked Munger how he thinks about downside protection and when to exit an investment.

In his typical matter-of-fact fashion, he confessed he's not a great 'exiter' as he bought Berkshire in 1966 and has owned shares of retail giant Costco for decades. Munger went on to say that he is never trying to have to exit when he buys an investment. 

That message should resonate with you if you've ever stuck with an investment for many years to see firsthand the power of compounding dividends.

Most of our holdings have been in our portfolios since they launched in 2015, including Broadridge Financial (BR). This business helps banks, asset managers, and brokers work more efficiently and comply with regulations by handling tasks like investor communications, processing trades, and analyzing data.

A boring business by most measures, Broadridge has consistently grown as regulatory compliance needs have increased, financial institutions have outsourced more non-core functions, higher-margin digital communications have replaced direct mail, and the firm has expanded its product suite into adjacent markets.

When we bought our shares nearly a decade ago, Broadridge offered a 2% dividend yield. The company's dividend has more than tripled since then, so our initial capital now earns a nearly 7% annual return from dividends alone. And those dividends look set to continue growing around 10% per year.

With the company continuing to perform well and shares looking reasonably valued, why would we ever want to part with an investment like this? Especially since we've seen Broadridge navigate bear markets, a pandemic, periods of high and low interest rates, and much more with its fundamentals intact, giving us all the more confidence to hold through good times and bad.

Buying a dividend growth stock gives you a stake in a productive asset – a company that can innovate and become more efficient to grow its earnings and pass along part of your share of those profits in the form of a stable and rising dividend. And as earnings and dividends grow, share prices follow over time.

These are unique benefits compared to money markets, high-yield savings accounts, and bank CDs, which have exploded in popularity in recent years with risk-free yields topping 5% for the first time in nearly two decades.

During past rate-hiking cycles, investors have stuffed cash into retail money market funds (black line below), which have seen their assets nearly double since the Fed started hiking rates in 2022.

The bad news for savers is that high rates aren't guaranteed to last. Vanguard's money market rate (blue line) has moved in almost lockstep with the Fed's interest rate (red line), creating a rollercoaster-like pattern over various economic cycles.

The Fed's latest projections, which should be taken with a grain of salt, indicate that rates could fall to around 3% by the end of 2025. If history is any guide, some of the funds in money markets could start being withdrawn over the next year or two as investors seek higher returns elsewhere.

The recent rally in dividend stocks could have some legs if a portion of that yield-hungry money migrates into income-oriented stalwarts like utilities, but your guess is as good as mine.

As a dividend growth investor, I don't need to sweat what happens next with rates, AI hype, or sector rotations.

While our portfolio's value will fluctuate unpredictably any given year, I expect the companies we own to collectively keep increasing their earnings power and the amount of dividends they pay us. The rest will take care of itself in due time.

Looking ahead, plenty of wild cards exist that could rattle the stock market as the presidential election nears, unrest in the Middle East rises, and the economy slows. There's always something to worry about.

Every week we (real humans, not AI or quant mumbo jumbo) comb through companies in our coverage universe to ensure our Dividend Safety Scores reflect the latest developments and our best assessment of risk.

Not all of our work makes it to the surface in the form of a research note, but please know we are constantly turning over stones. Our top priority is to help you navigate uncertainty and keep your portfolio between the guardrails.

As always, please feel free to reach out if you ever 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.