Sezeryadigal
Investment Thesis
My previous bullish thesis on the Schwab U.S. Dividend Equity ETF (NYSEARCA:SCHD) has been plenty convincing, as the stock has delivered a total return of 2.7% since mid-April.
My analytical update shows that summer is historically a good time to build up a position in SCHD, as the ETF typically performs quite well from October to December. Beyond seasonality, there are clear fundamental reasons to remain bullish on SCHD. I believe it is unlikely the Fed will start cutting rates anytime soon, as housing inflation is expected to remain elevated through 2027, propelling headline metrics. Additionally, the labor market remains very weak, and the current unemployment rate appears to be much lower than necessary to contain inflation. Overall, I reiterate my Strong Buy rating on SCHD.
Why I'm Still Bullish
First, we need to update you on SCHD's holdings. This ETF's portfolio is primarily weighted to the defense sector, with technology making up less than 9%. [compared to almost 34% in S&P 500]The financial sector has the largest share with 17%.
Understanding the breakdown of holdings is important because the massive rally in technology stocks in 2024 has made dividend opportunities like SCHD less attractive. We don't believe we're in a tech bubble as growth companies' earnings continue to expand. However, recent developments suggest that optimism for growth stocks from an interest rate perspective may be overvalued.
The Fed started the second quarter of 2024 expecting three rate cuts by the end of the year. We are only three months into April-June, but information from last month suggests there will only be one rate cut in 2024. Macroeconomic data indicates the Fed can hold off on further rate cuts, which I think will likely be a headwind for growth stocks.
The Fed's “dual mission” states that the organization has two main goals: to promote maximum employment and stable prices. Therefore, to better understand the Fed's next move, we need to look at two variables: unemployment rate and inflation.
Data by YCharts
Although the U.S. unemployment rate has risen recently, it remains low. At its current level of 4.1%, it is significantly lower than its average over the past decade. More importantly, it remains significantly lower than the non-cyclical unemployment rate of 4.4%. [NROU] The St. Louis Fed forecasts that NROU is likely a key indicator for the Fed's decision-making, since it is used to estimate potential GDP, according to the same source. Therefore, the situation surrounding the unemployment rate suggests that the Fed is unlikely to start cutting interest rates anytime soon.
From an inflation perspective, the situation is not so bright. If you look at the table below, you can see the breakdown of categories within the CPI basket. The bad sign is that most categories are still above the 2% target level. This means that there are a lot of unfavorable factors for the Fed to take into account.
Housing inflation is still well above 2%. Given that this item has a large weighting of 36% in the overall CPI basket, it is likely to continue to contribute significantly to high headline inflation. Furthermore, Goldman Sachs (GS) and Moody's expect home prices to continue to rise through 2027. In these circumstances, it is hard to expect housing inflation to decline. If the Fed starts cutting interest rates in the near future, mortgages will become more affordable and housing inflation will rise again. Since housing inflation is a large part of the CPI basket, lowering mortgage rates will likely also boost headline inflation.
The first quarter earnings season made it clear that market concerns about growth stocks were on the rise. The market retaliated by selling even prominent growth stocks that missed consensus expectations. For example, Salesforce (CRM) missed consensus expectations by just $13 million in revenue. Despite this slight shortfall, the market punished the company's stock very harshly, causing its share price to fall by about 20% in just one day. This indicates that expectations are so high that investors are likely to sell even if earnings are slightly disappointing. If growth stocks panic, I believe most investors will very likely seek out high quality stocks with high dividends, and SCHD is clearly one of them.
Finally, seasonality seems to be quite favorable for SCHD, meaning buying the stock after a weak June is likely a wise move. On the other hand, August and September have historically been weak months, meaning these two months could reduce potential gains from July. In summary, summer seems like a historically good time to add to a position, as the ETF has performed well over the past three months.
Now, let me explain why I prefer SCHD over its peers. Besides SCHD, there are two other notable dividend ETFs issued by Vanguard: High Dividend Yield Index Fund ETF (VYM) and Dividend Appreciation Index Fund ETF (VIG). I consider them peers because they have similar assets under management to SCHD and the same expense ratio of 0.06%. The reason I consider SCHD to be better than its competitors is because it offers a better balance between current dividend yield and growth rate. VYM's dividend yield is comparable to SCHD's, but its historical growth rate is nowhere near SCHD's. Meanwhile, VIG is much better than VYM in terms of dividend growth rate, but its TTM yield is much lower than SCHD's.
Risks to consider
The strong performance of big technology companies in recent quarters has been the main driver of the massive market rally. It appears that technology companies have been able to adapt to high interest rates and maintain and even improve EPS with the massive layoffs that began in the second half of 2022. However, they cannot cut staff indefinitely, which could lead to stagnant profits in the future. However, their ability to drive revenue growth through cross-selling new services should not be discounted, especially in an era of rapidly advancing AI capabilities. That said, if technology profits continue to surge in Q2 and the Q3 outlook is positive, my bullish view on SCHD will likely continue to underperform the S&P 500.
The global geopolitical situation is rapidly changing, including the continuation of a major military conflict and the imposition of sanctions on major oil producers such as Russia and Iran. For example, if there are signs of improvement in relations between Russia and the West, the market may interpret this as a possible easing of sanctions on Russian oil. If Russian oil becomes available to developed countries, it could upset the global supply-demand balance and lead to lower oil prices. Such a scenario could have a positive impact on inflation, prompting a more dovish stance from the Fed and sparking a new upswing in growth stocks.
Conclusion
In conclusion, SCHD remains a “Strong Buy.” The ETF offers solid exposure to the defensive sector and seems like a wise choice at this time given the market's optimism regarding the Fed's next move. In my analysis, the Fed has no reason to rush to cut rates and could disappoint growth investors soon. The first quarter earnings season made it clear that expectations for growth company earnings are so high that even the slightest earnings disappointment can lead to a massive sell-off.