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Weekly Market Analysis - The Strategy for Uncertainty? Raise Quality
Posted on3 Things to Know
September is Historically Negative for the S&P 500
The month of September is historically the only month that has a negative average return for the S&P 500 (-1.2% since 1930). The month of October averages a drop when counting only US presidential election years (-0.6%).
Allocate to Higher Quality to Deal with Uncertainty
Portfolios don’t “mature” on November 5. If you are fatigued by “soft landing” vs “hard landing” debates or put off by US election uncertainty, we’d favor allocating to higher quality dividend growth and investment grade yield strategies rather than attempt to “time markets.”
Dividend Growers have Consistently Outperformed
It takes a strong balance sheet and industry position to grow dividends consistently. A strategy of investing in consistent dividend growers (so-called “Dividend Aristocrats”) has outperformed the S&P 500 return over the past 30 years. While it has trailed the Nasdaq 100, it’s done so with 42% less average annual volatility.
Summary
Is the glass half full or half empty? As an investor, your answer might depend on your current portfolio allocation and preference of time horizon. As we discussed in last week’s CIO Bulletin, US equities have pulled back, unable to return to the July 16 high, a level that represented a roughly 20% year-to-date total return. The weakness of large cap US tech – off about 13% from the July high – is one indication of risk aversion that could dampen the overall equity market in the near-term.
We would note that a skittish performance of markets about two months ahead of an uncertain US presidential election is entirely normal. Weak data and weak markets frequently go hand in hand in late summer. Since 1930, the only month that averages a negative return for the broad US market is September (see chart).
Portfolio considerations
Reflecting uncertainty, “defensive” industries such as utilities have a history of outperforming the S&P 500 by 2.2 percentage points on average in the six-months prior to US presidential elections since 1990, then underperforming by 1.4 percentage points in the six-months after. Current market trends are conforming to this pattern. “High dividend yield” strategies have outperformed in the past two months, but this is partly a reflection of the sharp decline in large cap US Tech shares (The market cap weighted semiconductor index - comprised 60% of Nvidia – is off 22% since early July). We would tend to favor high quality consistent dividend growers over the “highest yielders” after recent market moves. We also doubt that a single AI-tech play will dominate markets in 2025. Small cap stocks – measured by the Russell 2000 – have a history of strong outperformance only in the first year of a new economic recovery. They have to go through a recessionary contraction before this happens. Since credit markets have been solid and there has been no “near death” moment for the Russell, we don’t see a particularly strong return outlook for lower quality SMID. As discussed in last week’s CIO Bulletin, higher quality, less leveraged SMID growth shares are a different investment.
Source: FactSet, Bloomberg as of August 29, 2024. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees, or sales charges, which would lower performance. Past performance is no guarantee of future results. Real results may vary.
September is Historically Negative for the S&P 500
First, we would note that a skittish performance of markets about two months ahead of an uncertain US presidential election is entirely normal. Weak data and weak markets frequently go hand in hand in late summer. Since 1930, the only month that averages a negative return for the broad US market is September (though many positives and negative have been experienced in particular years). When one includes only US presidential election year uncertainty, the weakness extends to October.
We are cautious of depending on historic patterns without assessing wider factors. But to date, it is notable that the composition of market activity is also following historic, election year norms. Defensive industries such as utilities, healthcare, and staples have typically outperformed a downwardly biased equity market in the six-months before US elections. On average, they go on to underperform a rising US equity market in the six months after US elections are out of the way.
Allocate to Higher Quality to Deal with Uncertainty
But what is a standout that may potentially endure through a variety of uncertain scenarios? The discipline of managing a firm to pay a higher dividend over many years “screens out” most firms, leaving a high-quality bias. This is not always what produces the highest return over short periods. Over cycles, it tends to eliminate heavily indebted firms.
Heavily indebted cyclical firms that survived economic crashes historically produced large “bounce-backs” in the year following the start of new economic cycles. While we often wish we could tell investors a more exciting story, no economic crash appears at hand, and certainly none has already happened. Without a large drop first, a stronger burst of performance for low quality leveraged cyclicals is not at hand.
Dividend Growers have Consistently Outperformed
What are some wider factors one should consider to understand markets now? For one, tech shares posted one of the five strongest outperformance periods in the past 25 years through early July. With just three US tech mega-caps rising to nearly $10 trillion in aggregate value in 1H 2024, returns were “sucked” out of other industries. Until 2Q of this year, EPS gains were sparce for most sectors. AI promises beckoned until the momentum faded. But since July, equity investors have turned to the tangible returns of high dividend yielders such as utilities as interest rates fell.
With tech correcting lower “high current yield” shares reaching record high levels, we would emphasize the left-behind dividend growth shares that have lagged. Tech (offense) and utilities (defense) are necessary components of a diversified equity portfolio. But even together, the two sectors wouldn’t make for a complete portfolio.
Election and economic policy uncertainty is likely to remain high until early November at a minimum. This should not stop investors from assessing if their portfolios are positioned to best suit their needs. The days of a 5% cash yield are nearly over with the Fed set to cut policy rates on September 18. So are the days when a single stock drove nearly a third of US equity market returns as Nvidia did this spring. Intermediate duration bonds are still yielding more than the Fed’s own expected policy rate over the next few years and can still benefit from Fed rate cuts, if marginally. Most global equities – apart from US tech – trade near long-term historic valuations.
