SCHD: A spy substitute for ETF investors (NYSEARCA: SCHD)


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Investment thesis: SCHB is a good SPY substitute. It is made up of similar companies but has a higher yield.

Introduction: ETFs now form the backbone of most portfolios. For example, a standard portfolio is made up of a ratio of SPY (for the S&P 500) and TLT (for the long end of the Treasury market). Additionally, due to low cost and high liquidity, an increasing number of investors and managers now favor ETFs that track broad averages over large mutual funds. Therefore, an analysis of a large index ETF such as the Schwab US Dividend Equity ETF (SCHD) is warranted on Seeking Alpha as it is now a standard investment tool used by many investors.

Before diving deeper into ETF analysis, let’s first look at the macro backdrop to make sure the economy is growing and an equity investment is appropriate. This is my standard methodology when analyzing an ETF like the SCHD.

I will be using the Leading, Leading, and Coincident Indicators methodology developed by Arthur Burns and Geoffrey Moore of the Federal Reserve.

Long lead

One of the main purposes of long-term leading indicators is to locate financial stress, which is usually a precursor to economic problems.

St. Louis and Kansas City Financial Stress Indexes

St. Louis and Kansas City FRED Financial Stress Indexes

Both St. Louis (left) and Kansas City (right) have low financial stress indices.

Yield M2 and BBB

M2 and BBB yield FRED

Liquidity is plentiful, as shown by the growing M2 figure (left). However, BBB yields have risen this year in sympathy with the broader bond market.

the the corporate earnings picture is strong (emphasis added):

The picture emerging from the fourth quarter earnings season is one of continued strength and momentum. Despite the well-known headwinds of cost pressures and logistical bottlenecks, an above-average proportion of companies were able to exceed estimates.

In fact, the proportion of companies beating consensus revenue estimates is actually higher than what we saw in the previous earnings season for this same group of companies, with the gains beats almost the same.

The main indicators

New orders for durable consumer goods (left) and capital goods (right)

New orders for durable consumer goods (left) and capital goods (right) FRED

Durable consumer goods orders (left) are at elevated levels while new orders for non-military capital goods (right) are at their highest level in five years.

Building permit for 1 dwelling and average weekly hours

Building permit for 1 dwelling and average weekly duration FRED

Building permits for 1 dwelling are on the rise again (left). However, the average weekly hours of production workers are trending down slightly.

4-week moving average of initial jobless claims

4-week moving average of initial unemployment claims FRED

The 4-week moving average of initial jobless claims has fallen significantly.

Yield spread and S&P 500

Yield spread and S&P 500 FRED

The yield spread is positive (left) as the S&P 500 is still rallying.

Coincident indicators

Payroll, income, industrial production and retail sales

Payroll, income, industrial production and retail FRED

The payroll (top left) continues to rise. Income (top right) recently peaked but fell in the latest report. Industrial production (bottom left) continues to increase. Retail sales (bottom right) peaked at a very high rate last year and have been on a downward trend ever since. However, the overall level remains very high.

Economic conclusion: the overall picture remains very solid. However, there are a few areas of weakness – BBB returns, the S&P 500, declining earnings and retail sales. Combined with the Fed’s recent hawkish tone, now is the time to turn to larger, more established companies.

This is exactly what I argued earlier this week (emphasis added):

What should investors do?

1.) If you were in small caps and didn’t take profits, start doing it. The index is down more than 20% from November highs (although it has rebounded recently), meaning it is in a bear market.

2.) Think a lot about the main technical positions. The QQQ also takes a few hits. As of this writing, it is below the 200-day EMA with the shorter averages about to cross in a bearish move.

3.) Opt for higher dividend stocks and/or ETFs. These companies will have lower betas and the dividends will help stabilize stocks in a downturn.

The SCHD fits perfectly into this strategy:

SCHD is a market-cap-weighted fund whose selection universe includes only companies that have been paying dividends for 10 years. Within this universe, SCHD uses fundamental screens (cash flow to debt ratio, ROE, dividend yield and dividend growth rate) to construct its portfolio. The goal is to focus on quality companies with sustainable dividends. As such, this approach gives the fund a slight large-cap tilt and excludes REITs entirely. Individual stocks are capped at 4% and sectors at 25% of the portfolio. Its overall composition is reviewed annually, while the portfolio is rebalanced quarterly.

The dividend focus gives the ETF a current yield of 2.84%, which compares favorably to the SPY’s 1.3% yield. And the overall performance of the SCHD follows favorably that of the SPY.

SPY and SCHD comparison over 1 year

Comparison SPY and SCHD over 1 year (Stockcharts)

Over the past year, the performance of SCHD has tracked that of SPY. But over the past few months, the SCHD has started to outperform the SPY likely due to its higher yield.

The SCHD is a good SPY substitute. It has similar overall performance, has the same style of companies (mature, more stable), which should perform better in a rising rate environment. And the ETF has a higher yield than the SPY.


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