It's almost seven months since I issued a SELL recommendation for the Schwab U.S. Dividend Equity ETF (NYSEARCA:SCHD) in an article titled, "SCHD or Treasuries: Which is Better for Retiree's Income Needs.
You can see below how SCHD has performed since that article's recommendation.
Performance of SCHD After My Feb 16, 2023, Article
Since My Sell Call SCHD Severely Underperformed Treasuries For Investors in All Tax Situations
Since my February call, even with its dividends, SCHD has delivered shareholders a total return loss of 2.08%. This is particularly painful because had investors taken my advice in mid-February and bought Treasuries instead of SCHD they could have locked in a 1 year 4.354% yield free of state taxes. If they had built a ladder they could have done even better as there were 6 month Treasury bills available back then paying 5%. And then, I covered it in March this year.
Tax Sheltered Investors Lost Out
If you are investing in a retirement account it's obvious that a yield of 4.354% or higher is a better deal than the 3.32% SCHD was yielding as of last February. They suffered the full brunt of the loss of NAV and an inferior dividend which will compound at a slower rate than the income from a higher-yielding Treasury.
Investors in Taxable Accounts Lose Out Even if SCHD's NAV Doesn't Decline
Investors investing in taxable accounts argue that SCHD's dividends aren't taxed as harshly as the interest income from a Treasury. That is true, but a favorably taxed unrealized loss of over 2% does not compare well with a taxed gain over 4%.
And to add insult to injury, even after suffering the decline in share price shareholders holding it in a taxable account would have still had to pay both Federal and State taxes on its dividend, so which would further decrease SCHD's already negative total return.
Even if SCHD's price had not deteriorated, investors would have still been earning less income from SCHD's dividend than they would have received from Treasuries bought when I issued that "Sell" call. Back in February SCHD's yield was reported to be 3.32%. However, had you bought SCHD at its closing price on Feb 16, 2022, the day my article was published, your actual yield through the first six months of the year would have been less. SCHD closed at $76.75 per share on February 16 and has so far this year paid out $1.2612/share. This annualizes out to a yield of 3.29% on a cost of $76.75.
Retirees in the Lowest Tax Bracket Would Still Do Better with a Treasury
For investors in a taxable account the big advantage of receiving income from stocks instead of bonds or CDs is that qualified dividend income is taxed at a lower rate than ordinary income. For a single investor whose taxable income is below $41,675 or a married couple whose taxable income is below $83,351 there is no tax on qualified dividends at all. But investors with taxable income below those levels will be paying, at most, only a 12% Federal tax on earned Interest.
The 1 year Treasury yielding 4.354% taxed at 12% still leaves you with a 3.82% yield on your investment, which is far better than what they received from SCHD's 3.32% yield. And the Treasury's interest is not taxable by state or local authorities, but SCHD's dividends are.
Investors in the 24% Bracket Do Better with Treasuries Too
Even a well off retiree with enough income to land in the middling tax bracket that begins when income exceeds that $41,675 for a single person or $83,351 for a couple and who is paying a marginal tax rate of 24% on ordinary interest may have done better with that 1 year Treasury bill. After paying the 24% tax the Treasury it was still putting a 3.31% yield in their pocket, not the 3.29 SCHD actually paid out. And SCHD's 3.31% dividend would have been taxed at 15% by the IRS, leaving them with an after tax yield of only 2.81%. If the investor lived in a state that has an income tax, that yield would have been decreased further by state taxes, which the Treasury escapes.
That was the Past Now Let's Look Forward
Past results don't necessarily tell you what will happen with money you invest now. It's possible SCHD's price could shoot up delivering a superb total return. But is it likely? Let's look at the conditions in which you are going to be investing your money today.
SCHD Moves In Lock Step With the S&P 500
As I argued in my February article, SCHD performed as well as it did because it had only begun trading in 2011, which is when the Federal Reserve's Quantitative Tightening (QE) policy had forced interest rates to the historic lows they maintained for the next decade. The rates of quality dividend paying stocks were far higher than available Treasury or CD rates until 2022. This caused investors who were investing for income to bid up the prices of those quality dividend stocks, which are what SCHD invests in, so that they not only received a higher income yield, they saw gratifying capital gains.
Throughout that period, the U.S. market as a whole was experiencing a dramatic, relentless bull market, especially the large cap part of it. Remember, SCHD is market cap weighted and its fate is largely determined by the fortunes of the top 10 or so largest stocks it holds.
As you can see from the chart below, from its inception, SCHD's price has risen and fluctuated very much in sync with the broader large-cap market as exemplified by the S&P 500. That said, over its entire lifetime it has underperformed the S&P 500 because it's methodology screens out aggressive growth stock and it was those stocks, especially the big Tech stocks that drove much of the S&P 500's dramatic growth. The consistent dividend growing stocks that SCHD screens for tend to be mature companies whose earnings growth prospects are modest.
In the chart below you can see how SCHD's total return moved in very much the same pattern as did the S&P 500. I use the Vanguard S&P 500 ETF (VOO) to stand for the S&P 500 for this comparison purposes as it was back in 2011 the cheapest investable form of the S&P 500 available to investors.
SCHD vs VOO Total Return from SCHD Inception to 12/31/2022
The bull market we see graphed above ended with the advent of The Great Inflation V.2 in 2022. (The Great Inflation V.1 occurred from 1973 to 1982 which I remember clearly but many of you reading this were too young to notice.
This is what has happened to VOO and SCHD since inflation kicked in, in January of 2022:
SCHD vs VOO Total Return 1/4/2022 - 10/12/2023
As you can see, SCHD still mostly fluctuated in sync with VOO. Though it did not lose as much as VOO did in the decline that bottomed out in October of 2022 it did see its NAV drop significantly in 2022. It also did not recover as sharply as did VOO in 2022. From this we can see that when the market hits hard times, SCHD's dividend stocks can be expected to lose value, too.
SCHD Is More Concentrated in Banks than VOO
There is only one period we can see in this chart where SCHD did not move in lock step with VOO. That was in the period after the failure of Silicon Valley Bank (OTC:SIVBQ) that occurred on March 10, 2023 on SCHD's net asset value.
As I warned in my March article, SCHD's Annual Reconstitution Ignores Severe Deterioration In Financial Sector Health, because of its focus on dividends, SCHD holds a high percentage of banks and financial institutions. They have recovered over the short term since the SVB debacle, thanks to the Fed taking extraordinary measures. But if you follow banking news you will know that there are significant rumblings pointing to oncoming problems in the Banking sector, with troubled commercial property loans and rising consumer credit card defaults raising warnings. Further pressure on banks will definitely be reflected in SCHD's price, at least until its next reconfiguration in March of 2024 when it has the opportunity to dump some of its bank stocks.
The Fed Is Not Going to Be Lowering Rates Until 2025 at Earliest
SCHD's yield is not competitive right now because inflation is still a factor. And it is going to continue to be a factor for a lot longer than most investors currently believe.
Despite a lot of wishful thinking by talking heads who want you to buy stocks because that is what makes them money, the Fed has signaled repeatedly that it is not going to be lowering rates any time soon and may very well be raising them. Inflation looked like it was slowing for the past month or so, but it looked like it was slowing in the Mid-1970s only to roar back after the Fed began easing.
Powell has stated numerous times in the speeches he gives after each FOMC meeting that the Fed will hold rates at their current level until it has a lot more data convincing it that inflation has dropped to its 2% target and will remain there.
Typically his conferences focus on a single phrase or two defining it as "hawkish" or "dovish," without listening to the more nuanced points that Powell makes. I have listened to all of them this year and what I have heard has guided my investing, much to my satisfaction. Because the Fed has made it very clear that they will take their time bringing rates down. Instead they are doing what was traditional until QE, keeping rates a point or two above currently reported inflation rates. That is what they mean when they use the term "restrictive."
And the Fed has made it clear that they are looking at many months' worth of data before declaring victory over inflation. And that is where the challenge lies. Because two very troubling factors right now make it likely that inflation will turn out not to be tamed after all.
Strong Employment Data Persists
One is the strong persistence of the employment data. The Federal Reserve is legally bound to do two things: control inflation and support employment. The unemployment rate, which you can see broken out by states in this Bureau of Labor Statistics chart, is at a level that is, in many states, an all-time low.
Oil Prices Are Surging
The other issue is the price of oil, which has surged 24% since July, thanks to the actions of our supposed "allies" the Saudis.
Crude Oil Futures Since July 1, 2023
Rising Oil Prices Ripple Through the Economy
A sustained rise in the price of crude oil will echo through the entire economy. Most people understand that while rising oil prices might make some money for shareholders in oil stocks, it raises the price of transporting the goods manufactured by most other companies and also raises the price that the majority of consumers who are not rich enough to buy EVs must pay to drive to work, shop, and leave home for entertainment. It also raises the price of heating in rural regions where oil heat is still the norm.
But many don't understand that there is another reason that a rise in the price of oil will affect consumer prices: crude oil is refined into the petrochemicals used to make plastics, too. Plastics are a major component of everything from appliances, automobiles, siding, tech devices, and packaging.
It takes a couple months for the rising price of oil to show up in the prices of good, but it is already affecting how much consumers can spend, given the increases they are seeing at the pump.
The Fed governors, whatever you might wish to believe, are not stupid. Nor are they driven by the political agendas that drives so much of the news reporting you absorb. They see the factors that make it likely that inflation will persist and they will use the very limited tool set at their disposal to control it. Their main tool is the ability to raise the Federal Funds rate. They are not legally mandated to help the government deal with its debt, despite what may hear from political partisans. This means rates may very well rise another point, at least over the next few months and then settle at that higher rate to remain "restrictive."
The CPI will be reported Weds Sept 13, 2023, and it will be tempting to look only at the "core CPI" which doesn't include food and energy especially if it declines. But the consumer's ability to pay for anything else after paying for food, heat, and transportation can be very limited if those non-core food and energy prices rise.
Markets Can Fall And Stay Low For Years
Finally, if inflation persists it is quite possible that the market will enter the doldrums as it did the last time inflation was a factor in the 1960s.
Investors who have only been investing in stocks during the past decade have been lulled into a belief that the market will, of course, drop from time to time. But this only provides a nice "buying opportunity." The past decade has taught investors to expect stock prices to quickly revive and reach new highs. This has not always been the case.
As you can see from the chart below, the market has experienced long periods when stocks drop and then meander around, trading in a range for a decade or more.
Most online graphs displayed by brokers and sites such as this one only show you the price and total return of the S&P 500 going back to, at most, the 1990s. But the market has been trading far longer than that.
In this chart (found on Macrotrends.com) you see depicted the S&P 500 index price since 1927. It's historical data is inflation-adjusted using the headline CPI and each data point represents the month-end closing value.
The red lines I have added show you the periods when it took a very long time for the S&P 500 to recover its value after a sharp decline. The three periods highlighted are 1937 - 1954, 1968 - 1993, and 2000 - 2015.
Throughout all these periods, Treasuries provided a much better return than stocks.
Treasuries and Money Market Funds Offer Much Better, Safer Income than SCHD
As I write this, on the afternoon of September 12, my brokerage, Schwab, is offering the following yields on CDs and U.S. Treasuries.
Schwab Bond Offerings Sept 12, 2023, 2:51 PM
The smallest amount that will buy you a Treasury bond or CD in at Schwab is $1,000. If you have a smaller amount to invest, you can get a yield of 5.24% from Schwab's Schwab Value Advantage Money Fund (SWVXX). The yield on Vanguard's Federal Money Market Fund (VMFXX) is 5.27%. These money market funds are taxed by state and local authorities and their yields fluctuate weekly, so if you can buy a longer term investment you have a better chance of locking in a good rate. But they are a great place to accumulate the funds you will be able to use to buy Treasuries or CDs.
A Word About Brokered CDs
I currently am not enthusiastic about brokered CDs for retirees despite their higher prices because they are extremely hard to get out of. You will have to offer a price that results in a yield that is much higher than the current market rate to be able sell one if you need to get your money out before it matures. Treasuries are very liquid and you can sell them easily if needed at a price that reflects the current market rate. So while they will let you lock in excellent longer rates, do not invest in brokered CDs with any money you might ever need during the term of the investment. They are, however, suitable for younger investors' retirement accounts.
Don't Be Misled by "Yield on Cost"
Many of you reading here will be thinking that your yield on cost from purchases made years ago are higher than what you see here. But that is a faulty way of thinking. By leaving your money in SCHD you are for all practical purposes investing that money today at today's yield. And unlike the case with Treasuries, the yield on your investment is not guaranteed, nor are you guaranteed to receive the money you invested at some set time. If we go into a prolonged period of decline followed by plateau, like the periods highlighted above, you may deeply regret having counted on your fleeting capital gains.
Then too, if the economy suffers and company earnings contract dividends may be cut, or eliminated. If the prices of stocks decline dramatically executives may decide to put some of their profits into buying back share of their stock at lower prices instead of paying out dividends. If dividend investing goes out of fashion--and it has been very faddy over the last decade, the stocks that SCHD has to choose from, because of the way its rigid index methodology must pick stocks, may decline in quality.
Investors NOT Emotionally Attached to SCHD Are Buying Fixed Income
Finally, remember that the only reason the prices of the stocks making up SCHD will rise is if investors are willing to pay more for their shares than they cost now. You may be a devoted dividend investor with a large investment in SCHD which skews your perspective: we hate hearing bad news about the stocks we hold as they can challenge our sense that we can trust our decisions.
So you may be attached to your investment in SCHD. But those retirees and income-seekers who aren't already sitting with a lot of money invested in SCHD s aren't dumb. They look at recent results. They see how much better, and safer those Treasury rates are than the yields of questionable dividend stocks. They will invest accordingly.
The flow of assets into SCHD is already far less than it was during the years when Treasuries offered a .25% yield on your money. The chart below shows this. Keep an eye on it. You may see those flows reverse if rates remain at their current levels.
Asset Flows into SCHD 2019 - Now
A Final Word: What I Mean When I Advise "Sell"
If you have a huge capital gain in SCHD in a taxable account you will have to analyze how a sale would affect your overall tax picture. At a minimum, you might consider not reinvesting dividends and investing those dividends and any new money you have to invest in safer fixed income.
If you hold SCHD in a retirement fund, this might be a great time to take profits and invest the capital you receive in a safer higher-yielding Treasury that will compound at a far higher rate than SCHD with no threat to your invested capital.
Investing in inflationary times is very different from what we have experienced for many decades. SCHD was a fine investment when inflation was not a factor and rates were forced down to historical lows. Those days are over. Retirees, fortunately, now have a much safer way of generating income at a rate slightly higher than current inflation, while protecting their hard won nest eggs.
Psycho Analyst
Though I have done quite a few different things over the course of a long life, I am best known as a writer of bestselling books about business and health. My success has come because I am a very curious person who doesn't just follow the herd and trust whatever the experts tell us to believe. I do my own research. I collect the facts, look at them objectively, and draw my own conclusions. Over the years, I have been amazed at how much of what everybody "knows to be true" is based on poorly designed studies, many of them impossible to replicate. I approach Investing with the same open mind, challenging the orthodoxies that attract the herd, studying how things really work, and doing my best to come up with an approach, based on facts, that works for me and would appeal to those who find thinking worthwhile.
Analyst’s Disclosure: I/we have a beneficial long position in the shares of VOO, US1M, US6M, US12M either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
I am not a certified investing professional or registered investment advisor. I am just an ordinary investor with a lot of curiosity who enjoys researching stocks and sharing what I find with others. Don't buy or sell any security you read about here before doing your own research and considering opposing views.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
