Waiting Is the Hardest Part: Staying the Course With Dividends

The S&P 500 jumped another 3% in July, bringing its year-to-date gain to 20%. U.S. stocks have logged their longest monthly winning streak in two years. And optimism about equities compared to bonds has hit its highest level in more than two decades, according to an index tracked by Bloomberg.

Signs of falling inflation, a strong jobs market, and resilient economic growth have bolstered investors’ hopes that a recession will be avoided as the Fed finishes its monetary tightening cycle, with the latest rate hike in July potentially being the last.

Second-quarter earnings season has reinforced that view with over 80% of S&P 500 companies releasing results during the past few weeks. While corporate profits are tracking to dip for a third straight quarter, more than 80% of firms have beaten analysts’ earnings expectations, according to FactSet.

 

The stock market’s defiant rally has the S&P 500 trading at nearly 20 times forward earnings, a P/E multiple that was rarely exceeded in the past several decades. 

 

This relatively rich valuation for equities is even more surprising given the jump in interest rates. The last time the 10-year Treasury bond yielded near 4%, where it sits today, was in early 2008, when the S&P 500’s P/E ratio was below 15.

Mega-cap tech stocks have been the biggest driver of multiple expansion. The tech sector trades at nearly 30 times forward earnings, compared to its 10-year average of 19.4, per FactSet. 

Outside of consumer discretionary, which contains tech behemoth Amazon, all other sectors trade at P/E ratios that are no more than 10% above their 10-year averages.

 

As we discussed in July, this unusual environment has been tough for value-conscious dividend strategies. The appeal of defensive businesses that generate reliable cash flow and trade at reasonable multiples hasn’t been there for much of the past year.

 

But times like these, when “defense” is relatively cheap, can be among the most important moments to stay the course. Unlike the predictable income provided by quality dividend portfolios, the market’s emotions are erratic. Sentiment can change on a dime.

 

The feeling of complacency that has permeated the scene for stocks could still face challenges from the cumulative impact of monetary tightening, which has yet to be felt as borrowing becomes more expensive and difficult. Predicting the path of inflation remains murky too, especially if the jobs market and consumer spending stay solid.

 

I’m rooting for a soft landing but not getting my hopes up. I’m also not tinkering with our portfolios in anticipation of any of these tough-to-forecast macro events breaking a certain way. Great businesses have and will continue to manage through all types of environments while paying rising dividends and increasing their earnings power.

 

With certificates of deposit (CDs) and high-yield savings accounts now offering yields near 5% or higher, some investors might feel tempted to cash in their chips in today’s frothy market environment. Sitting on the sidelines hasn’t paid this well in over a decade.

 

Taking this action would provide higher current income compared to many dividend-paying stocks. And capital is preserved if the stock market sells off.

 

This strategy can make sense for money that is needed within a handful of years. But it’s not ideal for investors operating with a horizon spanning a decade or longer.

 

First, that 5% yield is not set in stone. As seen below, markets are pricing in rate cuts beginning in early 2024 and see rates falling below 4% by the first half of 2025. Who knows how stocks will perform over this period, but falling rates reduce interest payouts.

Putting cash in longer-term bonds like the 10-year Treasury provides more visibility but a lower yield near 4%. The challenge with an all-in bond strategy is that your interest payments remain fixed but your withdrawals need to increase over time due to inflation.

 

Once withdrawals exceed interest income, you’ll need to raise additional cash by selling some of your bond holdings. This creates a downward spiral where a smaller holding of bonds results in a smaller amount of interest income generated, resulting in a need to sell even more bonds to fund the gap.

 

The result is a shrinking portfolio that is unlikely to last 30 years. The chart below plots the balance of a theoretical $1 million portfolio invested in a 30-year Treasury yielding 3.7% (after tax) with $40,000 of annual withdrawals, adjusted 3% annually for inflation.

That said, higher bond yields have made fixed income securities interesting again. Pairing bonds with dividend growth stocks can provide a solid mix of current income and inflation-protected income growth. All potentially without having to sell any shares.

 

For more on this approach, I recommend reading our article comparing dividend stocks with bonds for retirement income. But the bigger point I’m trying to convey is not to make any rash asset allocation decisions in response to the continued rally in big tech or the emergence of tantalizing yields offered by CDs and other fixed income securities.

 

As Charlie Munger said, “It's waiting that helps you as an investor, and a lot of people just can't stand to wait. If you didn't get the deferred-gratification gene, you've got to work very hard to overcome that.”

The stock market is arguably the best place to park money for the long run as it has historically returned around 10% annually – double today’s interest rates. 

 

Timing the market by shifting in and out of fixed income securities risks missing out on this great way to passively grow wealth. Especially with many quality dividend stocks sitting out the tech-driven rally and maintaining reasonable valuations.

Thanks for reading!