Home Trading ETFs SCHB: Striking A Cautious Tone – Schwab U.S. Broad Market ETF (NYSEARCA:SCHB)

SCHB: Striking A Cautious Tone – Schwab U.S. Broad Market ETF (NYSEARCA:SCHB)

by TradingETFs.com
SCHB: Striking A Cautious Tone - Schwab U.S. Broad Market ETF (NYSEARCA:SCHB)

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Main Thesis

The purpose of this article is to evaluate the Schwab U.S. Broad Market (SCHB) fund as an investment option at its current market price. This is a fund I recommend for broad market exposure, and it is up sharply since I last covered it. With the Fed holding off on interest rate increases, strong employment numbers, and low levels of inflation, U.S. equities have been on a hot streak since 2019 began. While there is plenty of good news out there, the indices are now trading at record high levels, and I see some warning signs that make me cautious now. First, corporate earnings are coming in a bit mixed, with profit margins seeing a drop in all sectors, except Utilities. Second, investors sentiment has picked up markedly over the last few months, which is a metric I review constantly to use as a contrarian signal. Three, dividend growth for the broader market (as measured by SCHB’s distributions) is slowing. This fact, along with the rising share price, is keeping the fund’s yield below the 2% mark, which I do not find particularly attractive.

Background

First, a little background on SCHB. SCHB is managed by Charles Schwab and its stated objective is “to track as closely as possible, before fees and expenses, the total return of the Dow Jones U.S. Broad Stock Market Index”. Currently, SCHB is trading at $70.56/share and yields around 1.83% annually, based on the last four distributions. I recommend SCHB during my last review in January, as I felt the fund was a great way to buy in to the market correction. This turned out to be a good call, as the fund is up over 12% since that time, after accounting for distributions. With this large, short-term gain, I wanted to give an update on my macroeconomic view going forward. For now, I believe caution is warranted, and I will explain why in detail below.

Q1 Earnings – Good, But Profit Margins Declining

With earnings season currently underway, I want to begin the review with a look at the results we have seen so far. While not all companies have reported yet, we have seen at least some earnings calls from all sectors, which allows us to take in a broad view of how corporate America is faring. For the most part, the results have been historically good, with corporations continuing to benefit from economic growth, lower tax rates, and a U.S. consumer who appears willing to spend. However, expectations are also very high, which has sent some stocks plummeting even on modest revenue or profit misses.

With this in mind, I am going to be very critical of the companies and funds I own right now, before adding more cash to the market. And, so far, Q1 earnings have come in overall a bit below expectations, with profit margins dropping slightly in a year-over-year comparison in 10 out of 11 sectors, illustrated in the graph below with data compiled by FactSet:

Source: FactSet

As you can see, there has been a slowdown so far in terms of profit margins, most notably in the Energy, Information Technology, Financials, and Materials sectors. Companies are reporting higher costs as the culprit, both from input resources and labor, which makes logical sense considering the impact of both tariffs and rising wages. In other sectors, the declines have been slight, but they are present.

My takeaway here overall is mixed. On the one hand, these margins are very strong, and are high on a historical level. However, if the declines are maintained through the entire earnings season, it will be the first (year-over-year) decline in net profit margin since 2016 for the S&P 500. Again, even with the decline, the overall profit margin for the market is high, but so are stock prices. Investors are paying up right now to own these assets, and they will want to see continued growth in order to keep paying up. With profit margins dropping, albeit slightly, it may be hard to convince investors to keep putting new cash in to stocks at these levels.

Contrarian Look In The Other Direction

Back in January, the market was still reeling from a steep correction that began late last year, and stock prices were at relatively attractive levels. However, investors sentiment was still largely bearish, with individual investor sentiment reading at bearish levels above the historical norm. Furthermore, the sentiment was gaining momentum, as investors were likely still reeling from the pain the December drop produced.

With that backdrop, I was enthusiastically recommending stocks, as I viewed the resounding negativity as a clear contrarian signal to buy. While I did not time the bottom precisely (and I never do), the decision to put cash to work in January has been a very profitable play, in quite a short period of time. These gains have helped recoup Q4 losses, and then some. However, it also increased my equity positions to levels above what I normally allocate, so I have been looking for the right moment to scale back my positions, and the last month has been providing them.

Part of the reason for my re-allocation trades, has been a shifting of investor sentiment, which was a key reason for my buy decision a few months ago. Based on data compiled by the American Association of Individual Investors (AAII), a weekly Investor Sentiment Survey they publish illustrates the percentage of investors who are either “bullish”, “neutral” or “bearish”. While the level of bullish investors is identical to where it stood over three months ago, the bearish figure has dropped considerably, from over 36% to just over 20% now, illustrated in the graphic below:

Source: AAII

While this has not been a wild swing positively, a lot of bears have left the camp, and entered into the neutral sentiment column. While 20% may still seem high, it is not based on the historical average for bearish sentiment, which is 30.5%.

My takeaway here is that investors seem generally positive, but with stocks at record high levels and profit margins declining, perhaps they shouldn’t be. I am personally using these signals as a chance to put my contrarian hat on and shift to more defensive positions, and will continue to monitor all these metrics in order to time an appropriate level to take more risk again.

Q1 Dividend Growth Slowed

A final point related to SCHB specifically has to do with the fund’s dividend growth so far in 2019. While there was growth, it has slowed from 2018, which likely coincides with the declining profit margins I discussed earlier. While yields have been low in broad market funds for years, due to rapidly rising share prices, strong dividend growth can help buffer this trend. With a yield under 2%, year-over-year growth is always welcome.

On that point, the fund has seen some growth in Q1 but, as I mentioned, at a lower rate than the year below, illustrated in the chart below:

Q1 2017 Distribution Q1 2018 Distribution YOY Growth
$.235/share $.267/share 13.7%
Q1 2018 Distribution Q1 2019 Distribution
$.267/share $.278/share 4.0%

Source: Charles Schwab (with calculations made by Author)

As you can see, this is a marked turnaround from the prior year. Again, this is not a signal that, in isolation, is much to worry about. Distributions often fluctuate in ETFs from quarter to quarter and, given how strong dividend growth was in 2018, it was unrealistic to think those levels were sustainable long-term. However, given the size of the drop, coupled with the other factors I discussed, I think this provides another cautionary sign that investors need to consider.

Bottom Line

The end of 2018 reminded investors that markets can correct, quickly. While there was pain in the short-term, there was plenty of reward, for those with the courage to buy in when others were selling. I recommended just that back in January, using SCHB as a primary vehicle to do so, and the results speak for themselves.

However, the market has started to reclaim all time highs, and investors are noticeably less bearish than they were a few months ago, which are signs that tell me we may be topping out. Funds like SCHB offer plenty of diversification, but broad market funds are also very heavily weighted towards the Information Technology sector, given the sector’s strong performance over the past few years. As the chart below illustrates, SCHB has more than one-fifth of it assets exposed to Tech:

Source: Charles Schwab

While this is not “bad”, it does explain why broad funds like SCHB have fairy high P/E ratios, as high-flying stocks such as Amazon (AMZN), Facebook (FB), and Alphabet Inc. (GOOG) are top holdings.

With profit margins dropping across most sectors, including Tech, I see current levels as an opportune time to take some risk off the table. Given the mixed nature of the current earnings season, I do not see many short-term catalysts to drive the market much higher. Therefore, I am shifting to more defensive positions, at the expense of individual holdings and broad market funds, and suggest investors consider doing some of the same at this time.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

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