Hello, informed dividend investors!
Interest rates have risen steadily since early 2022. Corporate earnings growth looks very strong, but it's being stimulated by a capital expenditure cycle that creates immediate profits for suppliers while deferring the associated costs for their customers. Investors now face a choice between a richly-valued stock market and a bond market that looks attractive by recent history's standards yet has grown steadily less so amid stubborn inflation.
If you have any questions about our approach to dividend total return investing, please reach out — I’d love to hear from you!
And now, read on for our team’s thoughts on the current state of the market and economy.
Here’s to your continuing investing success!
Three Takeaways for Dividend Investors
AI gains are inflating earnings quality. Much of the S&P 500's 50% earnings growth came from Amazon and Alphabet's AI investment stakes, not operations.
Treasury yields rose anyway. The 10- and 20-year both climbed even with rates unchanged, tightening the competition for income investors' capital.
Dividend stocks are having a strong year. The Dow Jones Dividend Index is up 16% YTD, though its yield has compressed to 3.2%.
The Stock Market
The S&P 500 and the Dow 30 achieved new highs in the wake of second quarter earnings, with the NASDAQ still modestly below the highs achieved in early June.
Second quarter earnings increased an astonishing 50% on 15% combined revenue growth through early August according to FactSet’s Earnings Insight.
Investment gains at Amazon, related to its position in Anthropic, and at Alphabet, related to equity holdings including Anthropic and SpaceX, drove a meaningful portion of the earnings increase. Still, excluding these tailwinds, earnings in the second quarter grew more than 30%.
AI infrastructure providers and their hyperscaler customers caused the bulk of the historically anomalous earnings rise, while the energy sector enjoyed the fruits of surging commodity prices. Tariff refunds provided a further boost.
Profitability was strong throughout most of the market, with only the healthcare and real estate sectors reporting profit margins below recent averages. The S&P’s P/E multiple of 20 is only slightly above the recent average and could be justified if this level of corporate earnings is sustainable.
The big question is how much of corporate America’s surging profit growth is at risk if AI capital investments aren’t soon justified by paying customers. The revenues that Nvidia, Broadcom, Micron Technology, and other AI vendors are earning at historic profit margins are not being counted as expenses by their customers. They are investments which will be recognized as depreciation slowly over subsequent years.
Meanwhile, tax incentives permit companies to depreciate capital investments at an accelerated rate and save the resulting income tax up front. The system appears more profitable due to timing mismatches between revenues recognized now and costs recognized later. The hyperscaler’s customers, corporate America, need to ante up or else mounting depreciation will create an earnings drag in the future.
There is no reason to think the AI investment cycle will suddenly stop, but it could certainly slow. The largest spenders are devoting all of their operating cash flow already and are issuing stock and debt to push the envelope beyond what their operations can sustain organically.
Meta tacitly admitted that its investments had overreached its actual compute requirement, and it announced an initiative to resell the excess compute. Investors boosted Meta’s share price, seemingly rewarding the company for its efforts to produce more current period revenue from its recent investments.
Nvidia made headlines by partnering with six institutional money managers to raise $500 billion of investor capital for companies to spend on Nvidia chips and other AI infrastructure. The goal is to find investors willing to treat rapidly depreciating computing hardware as loan collateral. You can finance an iPhone, so why not a rack of servers?
The skeptic’s view is that AI equipment prices cannot be justified by end-market demand for AI applications, with prices being propped up by bidding wars between dozens or even hundreds of companies who all dream of becoming one of a handful of big winners. As competitors start to drop out, the price of AI compute should recede to its marginal cost of production. Pity the lenders in that scenario.
The Economy
Volatile energy prices are whipping around headline inflation statistics. July’s CPI reading showed a 0.1% increase, following a rather drastic 0.4% decline in June.
On a 12-month basis inflation cooled slightly to 3.4% from 3.5%. Core inflation, which strips out food and energy, is estimated to have eased from 2.5% in June to around 2.3% in July. There is a tendency for higher energy prices to work their way into the core reading with a lag, which could create some upward pressure going forward.
The Federal Reserve’s new chairperson, Kevin Warsh, gave his second Open Market Committee press conference on July 29, announcing the Committee’s decision to leave rates unchanged at the target range of 3.50% - 3.75%. Three of the twelve voters dissented in favor of a rate increase. The target rate has remained the same all year, with expectations for rate cuts giving way to expectations for increases. Those expectations are bending back toward unchanged. Like a World Cup match, the result is a lot of back-and-forth drama without much scoring.
Warsh’s press conference caused grumbling among the media. He deflected questions designed to tease out his thoughts about the likely timing and direction of the Fed’s next action. Warsh stated that he would prefer for the Federal Reserve to communicate less while listening to financial markets more. His point about less communication was a subtle rebuke of colleagues using their positions for clout or to stump for their own policy preferences. It’s harder to infer exactly what he meant by listening more to markets. What financial markets seem to be saying in the wake of the FOMC announcement is that this incarnation of the Fed looks more accommodative than anticipated.
Warsh has appointed five task forces to look at the Fed’s balance sheet, data collection, productivity estimates, communication strategy, and its treatment of inflation. Inflation has been above the Federal Reserve’s ostensible 2% target for five years, and perhaps cynically, it seems likely that Warsh’s Fed will devise a way to define inflation down.
When the government changes its inflation grading rubric, the outcome is always to reduce reported CPI. The last major methodological adjustments came in 1995 as a result of the Boskin Report under Alan Greenspan. The Boskin Report estimated that inflation was overstated by approximately 1.2% per year. The methodological changes resulting from the report reduced reported inflation statistics by an estimated 0.4%-0.6% per year. Now thirty years later the Fed may be priming to do something similar.
Rates & Yields
The yields on 10- and 20-Year Treasuries rose 0.21% and 0.14% through mid-August. Gold and silver increased 14% and 18% respectively as of this writing. Rising inflation expectations could explain all of those moves.
Dividend stocks have behaved well, appreciating like real assets rather than going down in sympathy with bonds.
The Dow Jones U.S. Select Dividend Index is up 16% year to date and is priced to yield 3.2%, down from 3.5% at the beginning of the year.
Conclusion
Accommodative fiscal and monetary policy and torrid reported earnings growth pave the way for steady stock market gains. Investors may wonder at what level all the good news is priced in, and we agree that certain market sectors may be priced beyond perfection.
However, valuations do not look unreasonable — as long as the underlying earnings can be sustained.
As always, we preach earnings growth and diversification. Don’t let your portfolio become too reliant on the continued strength of the stocks making all the news.
Our team’s search continues for well-managed companies at fair prices that can grow in any environment, especially when the going gets tough.
Here are our two most recent selections for stocks that meet rigorous standards for quality, reduced volatility, and reasonable returns in the face of choppy markets:
