When the Weather Changes

Some of you may remember that my dad grew up on a farm in northwestern Minnesota. For newer readers, his father made a living raising crops there after finally getting his own farm in the 1940s.

Spring on the farm began with a lot of waiting. First the snow had to melt, then the ground had to dry enough to work.

My dad remembers the older farmers walking into the field, pushing their fingers into the dirt, and deciding by feel whether the moisture was right for planting. Mostly, they made the best judgment they could and lived with the result.

My grandmother had a saying for that. There wasn't a bigger gambler than a farmer.

One spring, when my dad and his brother were still in grade school, their father came home from the fields early, which almost never happened. He looked worried and spoke quietly with my grandmother, and then her expression changed. My dad says it was almost like an electric current went through the house.

A heavy late-spring rain had flooded much of the freshly planted field. By that point, most of the year's money was already committed. Seed and fuel had been paid for, and the family still had to cover its living costs while they waited for whatever the harvest might bring.

And now there might not be much of a harvest. That possibility carried extra weight for my grandfather since he had seen fellow farmers lose their farms during hard times, including his own parents, and he never forgot it.

He distrusted debt and went without crop insurance, feeling the premiums ate up so much of the crop's value that it hardly seemed worth buying. Instead, he kept enough cash in reserve to carry the farm and the family until harvest.

The tension hung over the house as the season went on. The crop that finally came in wasn't a good one, but it was enough. They paid the bills, scraped by, and made it through without taking out a loan.

My grandfather wasn't trying to eliminate risk. He knew that wasn't possible in farming. But he tried to structure things so that neither a bad season nor a run of good ones would push him into a decision he might regret.

Today's market is testing that same discipline with conservative investors being pulled in two very different directions.

On one side, the 10-year Treasury recently closed above 5% for the first time since 2007. A Treasury held to maturity offers a known stream of income and a known date when your principal comes back, a kind of certainty that is understandably appealing to retirees.

On the other side, a relatively small group of technology companies has continued to drive extraordinary stock market gains.

Since ChatGPT was released in late 2022, the S&P 500 has gained more than 90%, with nearly three-quarters of that advance coming from just 20 companies, most of them tied to the AI trade. Bloomberg estimates that a broader group of technology-related companies now represents 51% of the S&P 500's market value.

Caught in the middle, a portfolio of steady dividend-paying businesses can feel harder to stick with. Why accept stock market volatility when Treasuries yield more than many high-quality dividend stocks? And if you're going to own stocks anyway, why stick with slower-growing businesses when technology has produced much stronger recent returns?

Those are fair questions, but they also raise a broader one about how much today's conditions should change the way we structure a portfolio for the next decade or two.

Near the end of my grandfather's farming years, crop prices and farm incomes had been strong, farmland values were climbing rapidly, and some farmers feared that if they didn't buy available acreage now, they might not get another chance. Rising land values also gave them more collateral to borrow against, making it easier to keep expanding.

My grandfather saw it differently. He didn't think the prices being paid for land could be supported by what the crops grown on it were likely to earn. So while others borrowed aggressively, sometimes putting farms they already owned at risk to buy more, he stayed on the sidelines.

Agriculture had enjoyed years of strong prices and rising land values, so the optimism wasn't baseless. The problem was what happened when some farmers built their finances around those conditions continuing.

By the early 1980s, crop prices weakened, borrowing costs rose sharply, and land values fell, leaving farmers who had stretched their balance sheets to keep buying in a much more difficult position.

I don't view the rise of AI and technology as simply another farm bubble. Many of the companies leading the market are producing extraordinary earnings growth, and technology may deserve a permanently larger place in the economy and the S&P 500 than it had in the past.

What feels familiar is the temptation to let a powerful trend change how much risk we're willing to take. There is a difference between recognizing that the world has changed and building a portfolio that depends on one particular version of that future continuing to unfold.

My grandfather's cash reserve was there for a practical reason. He didn't think cash was better than farmland, but he wanted enough of it on hand so a flooded field or disappointing harvest wouldn't force the family to borrow or make a risky decision under pressure.

I think Treasuries can serve a similar role in a retirement portfolio. A 5% yield is now high enough to get your attention, and retirees shouldn't feel compelled to take stock market risk with money they may need in the near term. Cash and high-quality bonds can provide stability, dependable income, and funds to draw from when stock prices happen to be down.

At the same time, the higher yields now offered by Treasuries come with their own trade-offs. Inflation is a big one.

Suppose $1 million invested in 10-year Treasuries pays $50,000 a year. If inflation averages 3%, that final $50,000 payment would be worth only about $37,000 in today's dollars, while the $1 million principal returned at maturity would be worth about $744,000.

A healthy business can behave differently. If its earnings and cash flow grow over time, its dividend can rise as well, helping preserve the purchasing power of that income. And over longer periods, share prices tend to follow the growth of the businesses behind them, giving investors an opportunity to grow their principal as well.

That's why I think the more useful question isn't which asset looks best right now but rather what job each part of a portfolio is supposed to do.

Cash and bonds can provide stability, dependable income, and help fund near-term spending. Productive businesses can provide income today while giving that income and the value of the underlying investment an opportunity to grow over time. Neither role makes the other unnecessary.

For retirees, one advantage of dividends is that they tend to be far steadier than stock prices when backed by time-tested businesses with strong balance sheets. Share prices can react to interest rates, headlines, sentiment, elections, and other forces that may have little to do with what a company actually earned.

That relative stability can make it easier to stick out the lean harvest years. An investor who can cover a meaningful share of living expenses from dividends and bond interest has less reason to worry about whether the market happens to be up 20% or down 20% when the bills come due, and less pressure to sell shares during a downturn.

We are seeing a version of this play out right now. As long-term Treasury yields have moved higher, rate-sensitive dividend stocks have come under pressure.

Since late July, the utilities sector (XLU) has fallen about 14% while Realty Income (O) has declined roughly 16%. With Treasuries now paying over 5%, the dividends from these stocks look less attractive by comparison, so investors are willing to pay less for them. Higher rates also raise borrowing costs for capital-intensive businesses like utilities and REITs, which depend on debt to fund their growth.

That backdrop is why balance sheet strength remains such an important part of how we evaluate dividend safety and build our model portfolios.

With one exception, every holding across our three portfolios is either rated investment grade or practically debt-free, and about two-thirds of the portfolios by market value are rated A- or better. The typical holding has only around 10% of its debt tied to floating short-term rates, too.

By our estimates, refinancing debt coming due over the next two years at today's rates would trim earnings by roughly 1% to 2% for the typical portfolio company. That could mean somewhat slower growth in the near term, but the impact should be manageable for financially healthy businesses.

Seen in that light, the recent declines in utilities, REITs, and other rate-sensitive dividend stocks are also a good reminder that price and income can tell very different stories. A falling share price does not necessarily mean a company's earning power or dividend safety has deteriorated by anything close to the same amount.

Home Depot offers a useful reminder of how misleading those difficult stretches can be. A recent Wall Street Journal article shared that $1,000 invested in the company's 1981 IPO, with dividends reinvested, would be worth roughly $16 million today, making it the highest-returning U.S. stock over those 45 years.

However, that outcome looks obvious only in hindsight. From around the turn of the century through the 2008 financial crisis, Home Depot's stock fell over 70%, leaving shareholders with a long stretch of disappointing results. Yet the company kept paying its dividend throughout that period and has now paid one every quarter since 1987, nearly four decades.

For an investor living through those years, it would have been easy to wonder whether the company's best days were behind it. In hindsight, they clearly weren't, which is a useful reminder of how little a few difficult years can tell us about what a sound business may accomplish over several decades.

That is the long game dividend investors are playing. The goal isn't to own whatever happens to be leading the market today, but to own proven businesses that can keep earning money, return some of it to shareholders along the way, and ideally grow those payments over time.

My grandfather couldn't avoid uncertainty. He had to plant before he knew what the season would bring, and he had no way of knowing when crop prices, interest rates, or farmland values might change. What he could control was how dependent he became on any one outcome.

Retirement portfolios aren't so different. We want dependable assets to help fund near-term needs, productive assets to grow income and protect purchasing power over time, and enough diversification that no single forecast has to be right for the plan to work.

Perhaps most importantly, we need a portfolio we can stick with, and dependable dividends and interest can make that easier when markets inevitably test our patience.

The weather will change again. We just don't know when or in which direction. The goal is to own a portfolio that doesn't require us to know.

Thank you for your support of Simply Safe Dividends, and please reach out with any questions or ideas for how we can keep improving the service for you.