Margin Debt Surge Raises Concerns in Stock Market

Fundstrat has noted that surges in margin debt often precede market declines. Their analysis indicates that after a 40% increase in margin debt, the median performance of the S&P 500 has been a 4.2% decrease over the following year. Greater rises in margin debt correlate with poorer market returns in subsequent months. Investors frequently need to quickly reduce their margin debt during downturns, intensifying selling pressure. Additionally, the CAPE ratio recently reached its second-highest level ever, and historical data suggests that stocks often regress once the Federal Reserve initiates a rate-hike cycle, which it recently did after a three-year pause.

Despite these warning signs, there is no immediate cause for bearishness, but a level of caution is warranted. To adapt to the current market signals, I am accumulating cash by divesting from some lower-conviction assets and being more selective with new investments. I am prioritizing less volatile options, particularly high-quality dividend-paying stocks with a history of consistent dividend growth.

Research from Ned Davis and Hartford Funds indicates that dividend-growing companies tend to yield the highest returns with the least volatility. One preferred investment vehicle for these quality dividend growth stocks is the Schwab U.S. Dividend Equity ETF (SCHD), which features 100 top dividend stocks vetted across various quality metrics, including growth rate, current yield, and financial stability. This ETF currently offers a yield of 3%, based on its trailing distributions, and includes firms that have raised their dividends at an average annual rate exceeding 9% over the past five years.

The ETF includes notable stocks such as Procter & Gamble (PG), which is weighted at 4.3%. Procter & Gamble has increased its dividend for 70 consecutive years, earning it the status of Dividend King. The stock currently offers a yield close to 3%, significantly higher than the S&P 500’s yield of approximately 1%. My confidence in P&G led me to bolster my holdings in this stock for its stable revenue and attractive valuation, making it a solid defensive option in the current climate. Its low valuation and high yield suggest it doesn’t require rapid growth to generate appealing long-term returns.

While accurately predicting market movements remains elusive, the current signals underscore the need for caution. I am adjusting my strategy by selling lower-conviction positions and increasing my investments in dividend growth stocks through SCHD and by acquiring high-quality companies like P&G. Although these adjustments won't shield my portfolio from a market drop, they may help mitigate losses and still allow for potential gains during market recoveries. The liquidity from selling lower-conviction positions and accumulating dividends will afford me the flexibility to invest further during significant market declines.