March 25, 2021
Despite a global pandemic the likes of which we have not seen since 1918, the S&P 500 returned +18.4% in 2020 (in USD). Underneath the surface, the distribution of returns paints a much more detailed picture. 77% of the return in the index was attributed to 10 stocks (primarily mega-cap tech names). Our previous blog highlighted what short-term strategies have worked in the markets in 2021 thus far. Companies with low quality, low growth, and high volatility characteristics have outperformed and now must deliver after largely pricing in a recovery in our minds. These are not candidates for inclusion in Bristol Gate portfolios.
The trends in the market appear to be shifting – rising rates and fears of inflation have given investors pause. What do these trends mean for the markets moving forward?
As seen below, rising interest rates do not necessarily mean equity market weakness in the near future. In fact, the opposite has been true historically over the past three decades. The biggest risk by far of rising rates lies in the fixed income market where yields have been compressed, even small changes in rates will have a big impact on bond prices. Some of that fixed income money could find its way into equities providing support to the markets.
Source: “Rising Interest Rates are a Good Sign for Stocks”, Sam Ro. Yahoo Finance.
Within equities, we believe much of the recent underperformance of dividend stocks through the pandemic and recovery thus far can likely be attributed to the low interest rate environment. The low discount rates applied to future earnings of non dividend paying high growth stocks made growth an attractive segment of the market. As this trend in interest rates reverses and discount rates increase, the non dividend paying growth universe may give back a substantial amount of its relative gains.
Data Source: Ned Davis Research Inc. Past performance is no guarantee of future results. Data shown is based on the average 36-month performance after all rate hikes since 1972 which occurred on the following dates: 1/15/73, 8/31/77, 8/31/80, 9/4/87, 2/4/94, 6/30/99, 6/30/04, 12/16/15.
The chart above shows that in previous rate hike cycles, high dividend growers have historically performed well and provided a strong hedge in equity portfolios against rising rates and inflation. We believe companies that are growing dividends off strong fundamentals will once again be rewarded through this uptick in interest rates moving forward, particularly if they are attractively valued and can grow cash flows above inflation.
[1] https://www.eea.europa.eu/publications/covid-19-and-europe-s/covid-19-and-europes-environment
[2] https://www.ncbi.nlm.nih.gov/pmc/articles/PMC7498239/
[3] A universe consistent with our investment process (three years dividend history, investment grade rating, etc.) was used for this analysis.
Important Disclosures
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