Dividends will Dethrone Tech

Here's how to play it.

There are just a couple weeks left in 2023. And after spending much of the year well in the red, dividend stocks are back in the black for the year, across the board.

The rally’s primary catalyst is the Federal Reserve. Starting in March 2022, the central bank raised the benchmark Fed Funds rate at the fastest pace since the 1980s. Now speculation is boiling over that the Fed is on the verge of declaring victory over inflation, with interest rate cuts on the horizon. And investors are rediscovering the value of dividends with a vengeance.

To be sure, this year has belonged to the biggest technology stocks. Led by the names most associated with artificial intelligence—such as NVIDIA Corp (NSDQ: NVDA) with more than a triple—the Nasdaq 100 (NDX) is up better than 50 percent.

Big Tech strength has put the S&P 500 on track for a return of better than 18 percent for the fourth year in five. By comparison, despite the big Q4 rally so far, the iShares Select Dividend ETF (DVY) is still up by barely a percentage point year to date.

The big question as we get ready to ring in the New Year: Will anything will change in 2024?

Will Big Tech stocks, despite record high valuations, continue to move higher, sucking in the lion’s share of investor dollars? Or will dividend stocks finally take the lead in a still rising stock market as interest rates become less of a concern? And have interest rates stayed high enough for long enough already to push the US economy into recession next year—taking the entire stock market down with it?

It doesn’t take many years of investing to notice the simple truth that Wall Street fashion is notoriously fickle. In fact, 2022 was basically the mirror image of 2023: The DVY outperformed the S&P 500 by almost 20 percentage points and was 33 points ahead of the Big Tech NDX.

The Wall Street consensus has thus far grossly over-estimated how much rising interest rates would affect dividend paying companies’ earnings and guidance. That’s been very good news for investors, as better run companies have continued to boost dividends.

Stock price performance, however, results primarily from perception about the future, rather than actual business results. And based on investor sentiment for most of this year, it’s hard to see best in class dividend stocks even returning to pre-2023 levels, at least until the Federal Reserve actually starts cutting interest rates. Such big recovery gains are even less likely if the economy does hit recession.

It’s clear the Fed’s upward push on borrowing costs has had a measure of success quelling short-term inflation pressures. But that’s been largely at the expense of economic growth. And by crunching investment in everything from supply chains to basic housing, food and energy, the central bank has basically guaranteed we’ll see even higher inflation down the road.

Longer term, absent some fresh thinking at the Fed, we’ll see even more severe tightening next time, which will produce still higher inflation and so on. That is, in fact, precisely what happened from the late 1960s up until the late 1980s—when a vastly improved environment for trade and investment at last began to narrow the chronic gaps in supply for vital areas like housing, food and energy. And for now at least, Fed doctrine is you fight inflation by raising interest rates.

The dividend stock rally we’ve enjoyed since early October began when best in class companies reported that earnings, balance sheets, growth plans and dividends are holding up well in 2023, despite paying considerably more for interest expense. But it really kicked into gear when voting members of the Federal Open Market Committee started to indicate they may be finished raising rates for this cycle, which immediately triggered investor speculation that interest rate cuts are imminent.

That’s taking a lot on faith in my view. For one thing, the Consumer Price Index numbers released last week included signs inflation is far from quelled even in the short term, for example the 5 percent year-over-year lift in rents. And FOMC member statements continue to indicate they’re willing to keep  rates at much higher levels than we’ve seen in literally decades until headline inflation numbers decline further.

Lower rates and a soft landing for the economy are of course the best conditions for the market in general in 2024, and dividend stocks in particular. Not only would see a recovery based on falling risks to businesses and dividends. But there would also likely be sector rotation from Big Tech stocks now trading at their highest valuations since the late 1990s.

And gains could be quite explosive. There was no DVY ETF in calendar year 2000, the year 2024 appears to be shaping up to be most like. But the Dow Jones Index it’s based on returned almost 25 percent that year, versus a -9.1 percent decline in the S&P 500. And the Dow Jones Utility Average returned 51.1 percent, the Bloomberg REIT Index 28.8 percent and the Alerian MLP Index 45.7 percent.

It was, in other words, a very good year for dividend stocks in 2000. And while the wreck of Enron dragged down utilities in 2001, REITs (up 12.9 percent) and midstream MLPs (up 43.7 percent) kept the high yield party going that year. That was even as the S&P 500 lost another -11.9 percent and the Big Tech NDX recorded its second big down year in a row to close out -57.4 percent below where it ended 1999.

In 2000, the Alan Greenspan-led Fed was able to bring interest rates down slowly enough to avoid a major recession. This time around, however, there’s still a decent risk the Fed has already kept interest rates high enough for long enough to push the economy into the proverbial ditch. And if that proves to be the case, it’s tough to see even the high quality stocks in this portfolio emerging wholly unscathed from what would likely be a market-wide selloff.

So how do we play this? I suggest the following.

First, stick with high quality companies only. That means businesses able to weather a possible recession next year, thanks to reliable revenue, strong balance sheets, latitude to cut operating and capital costs and relatively few contingencies outside management’s control.

Second, keep some cash on hand. Obviously, we’re going to perform better with less cash if the best case wins out. But money market funds are still yielding better than 5 percent. And so long as that’s the case, investments even in the safest stocks should be incremental. If you’re thinking of building a position in a stock, consider buying one-third of what you intend to own now. Buy the next third in 4 to 6 weeks and the final third a month or so after that. You won’t lose any ground with income. And you’ll be able to take advantage of any future selloff.

Finally, if you want to take a loss on a stock to offset gains elsewhere, consider taking a position in a similar company at the same time. For example, if you’re selling an electric utility stock, consider buying another utility at the same time. That way, you’ll be able to participate in whatever is left what’s shaping up as a Santa Claus rally in income stocks even while you lower your tax bill.