- The market is experiencing robust earnings growth, low inflation, and solid GDP figures, leading many to feel bullish despite underlying economic challenges.
- While valuations are high, investors are banking on an “immaculate soft landing” for growth, making high-quality dividend stocks an attractive choice.
- I’m gradually shifting my focus to high-yield dividend stocks, anticipating better risk/reward scenarios compared to the S&P 500 (
in the coming years.
Introduction
Everyone’s bullish!
At least, that’s what seems to be the case.
- Earnings growth is robust.
- Inflation is still in a long-term downtrend.
- The Fed started cutting rates.
- Geopolitical events have not caused energy prices to explode.
- GDP growth is solid and supported by consistent consumer spending.
As we can see, Atlanta Fed estimates are for real GDP growth of 3.4% on an annualized basis.
Although the economy is dealing with issues, like the fact that inflation has become sticky, lower-income consumers are not in a great spot, and the leading ISM Manufacturing Index has been hinting at contraction, the market focuses on earnings, which continue to be strong.
While most S&P 500 (
Bullish sentiment has provided the S&P 500 (
In light of this bullishness, Bloomberg wrote an article with the title “Wall Street’s Nonstop Rally Mints New Class of Hardcore Bulls.” This article included the quote below, which hits the nail on the head. The market behaves as if the business cycle is reversing.
To Philip Camporeale, a multi-asset portfolio manager at JPMorgan Asset Management, it’s almost as if the economic cycle is “aging backwards and extending, because the Fed is easing policy with a very low probability of recession,” he said. “Macro volatility is lower today than it’s been over the last two years,” he added. Camporeale maintained the overweight in stocks relative to bonds he’s had all year and is adding riskier bets such as emerging markets equities.
While one can make the case that the labor market is clearly signaling a “late-stage” economy, the market seems to behave as if the Fed is starting a new cyclical upswing.
Essentially, even highly paid analysts are overwhelmed when it comes to explaining at what point of the business cycle we are. And, to be honest, there are good arguments for both a slowdown and a recovery, as weird as that may sound.
For example, if the ISM Manufacturing Index recovers, we could see a whole new upswing in the industrial sector. The multiplier effect of that rebound could prolong the current economic cycle.
That’s why the Federal Reserve is such a big factor. Although it risks a scenario of prolonged above-average inflation by cutting rates into an economy that is everything except weak, it prolongs the business cycle by making it cheaper to borrow.
This also explains why “risk-on” ETFs have seen massive inflows recently.
Even better is the fact that market strength is broadening.
As most readers may recall, one of my theses is the broadening of market strength. Since the summer of last year (when AI became mainstream), the market has mainly been led by the FANG+ group. This pushed the weighting of the top ten S&P 500 holdings to almost 38% in recent months.
Since then, the weighting has come down a bit, as the non-FANG+ S&P 500 members are performing a lot better.
In fact, the equal-weight S&P 500 (
So far, so good.
What we have discussed in the first part of this article is far from bearish. However, there are some issues we need to discuss, as the situation is not as rosy as one might expect.
Hence, in the next part, we’ll discuss what these challenges are. At the end of this article, I will provide some food for thought in the form of investments I’m buying and monitoring.
It’s All About Valuations & Growth
The fact that “everything” seems to be going up and the sentiment is extremely bullish has created a situation where valuations have become lofty.
For example, one of the charts I have often shared is the one below. The updated version shows that the market trades at almost 22x forward earnings. That’s the highest valuation since the early 2000s (excluding the pandemic).
Although there are other factors at play that I will get to in a second, it needs to be said that the higher the valuation, the lower the implied future return.
This is what Apollo Global Management Chief Economist Torsten Sløk wrote on October 18 (based on the chart below):
Looking at the historical relationship between the S&P 500 forward P/E ratio and subsequent three-year returns in the benchmark index shows that the current forward P/E ratio at almost 22 implies a 3% annualized return over the coming three years, see chart below. In other words, when stocks are overvalued like they are today, investors should expect lower future returns.
These numbers make sense. After all, when stocks are cheap, it’s much more attractive to put money to work on the stock market, which supports longer-term returns. When stocks are expensive, the opposite is the case.
Goldman Sachs agrees, as its baseline model sees 3% annual returns over the next ten years. As we can see below, its model has a great track record.
The reason why valuations have gone up so much is because investors are pricing in the perfect scenario for growth.
“Equities are pricing an ‘immaculate soft landing,’ driven by double-digit profit growth without major disruption to the labor market and consumption,” she noted. “Bonds, for their part, have rallied aggressively, suggesting recession and intimating that the Fed is ‘behind the curve’.” – Bloomberg
This has happened before. As we can see below, scenarios where economic growth can withstand elevated rates are bullish. It happened in the 1990s, in the early 2000s, and it is currently happening as well.
All of this indicates that growth is extremely important.
Elevated valuations are only warranted if the economy remains strong. New risks of a recession could easily cause stocks to sell off again. One of the reasons is that lofty valuations also come with the situation where the 10-year government bond is above the S&P 500 earnings yield (inverted P/E ratio). This means bonds are relatively more attractive than stocks.
Since the early 2000s, stocks were much more attractive, which fueled elevated gains.
With that said, to give you an idea of current growth expectations, the market expects growth to support current valuations. As we can see below, consensus estimates are 9% EPS growth in 2024, potentially followed by 15% and 12% growth in 2025 and 2026, respectively.
Given elevated expectations, any downside adjustments to growth numbers are likely to cause disappointment (meaning: stock market corrections).
So, what does this mean for investors?
Dividends Matter & Food For Thought
I am not a typical high-yield investor. As I am not planning on retiring anytime soon, I am still focused on dividend growth over income.
However, I have started to buy more high-yield stocks since last year. This includes family accounts. In one account, I have reduced monthly investments in the S&P 500 and decided to focus more on high-quality dividend stocks with above-average yields.
The theory behind it is quite simple.
Given the elevated probability of subdued S&P 500 returns in the years ahead, a bigger part of the total return (capital gains + dividends) will come from dividends.
This is supported by data. As we can see below, low relative valuations have preceded outperformance for high-yielding dividend stocks.
Moreover, according to Morgan Stanley, when inflation is falling but at above-average levels, high-yield dividend stocks in defensive areas tend to outperform.
I believe the market is slowly warming up to the idea that higher-yielding stocks are attractive, as the ratio between the Vanguard High Dividend Yield ETF (VYM
In fact, the ratio is still at pandemic levels. Despite the AI trend, investors who bought high-quality dividend income in 2021 have not underperformed the S&P 500 since then.
Going forward, I expect the risk/reward for these dividend stocks to be MUCH BETTER than the S&P 500’s risk/reward.
With that said, under no circumstances should investors do one of these two things:
- Sell everything and push every penny into high-yield stocks.
- Pick dividend stocks based on their yield.
Personally, I’m making gradual changes. I am slowly adding high-yield picks to my portfolio and my family’s portfolio. We are not selling anything but expanding our portfolios by adding income-focused assets. This allows us to improve our risk/reward without betting our financial future on a specific thesis. Even if I’m completely wrong, the financial downside is extremely limited.
We also maintain our focus on quality. As I wrote in a recent article, it is very easy to buy “sucker yields.” Please consider reading that article if you’re new to high-yield investing. Too many people buy stocks with super high yields just to find out their total return is horrible.
To provide you with some food for thought, I really like a few areas for income. Among others:
- Real Estate.
- Energy.
- Beaten-down consumer staples.
- Non-banking financials.
Especially energy and REITs are great for a scenario where inflation remains elevated on a longer-term basis.
To give you some examples, in the energy sector, I like midstream companies. These companies own pipelines and related assets that allow upstream companies to produce oil and gas and ship their products to customers. Because these operations are mainly fee-based, they are not subject to oil and gas price fluctuations.
In this industry, I own Antero Midstream (AM
I also like upstream companies with special dividends. This includes Canadian Natural Resources (CNQ
I am also a big fan of Viper Energy (VNOM
, which own oil and gas mineral rights. These companies have ultra-high margins and elevated dividend yields in the 5-10% range, depending on the price of oil and gas.
In real estate, I’m looking at 3-4%-yielding industrial players like Prologis (PLD
In the financial sector, I like (and own) CME Group (CME
Additionally, I like consumer staple companies like PepsiCo (PEP
In the years ahead, I expect almost all of the companies I just mentioned to beat the market.
Also, needless to say, going forward, I will provide a lot more in-depth research on high-yield picks, as I am convinced my thesis will remain relevant for at least the next five years. Maybe longer, if valuations and inflation continue to be a concern.
Takeaway
In today’s bullish environment, I believe it’s easy to get swept up by rising earnings and positive sentiment.
However, elevated valuations hint at muted future returns, making a shift toward high-yield dividend stocks increasingly attractive.
While I still prioritize dividend growth, I’ve started adding high-quality, higher-yielding names to my portfolio for better risk/reward potential.
In this case, I’m focusing on sectors like energy, real estate, and defensive staples, where inflation-resilient, income-generating stocks offer a strong alternative to lofty valuations in the broader market.
By carefully balancing growth with reliable income, I believe this approach will outperform the S&P 500 in the coming years.
However, gradual shifts, not drastic moves, are key.
Hence, going forward, I will put a lot more energy into providing in-depth research and finding the best stocks that come with income, safety, and long-term growth.