The market is reeling from its worst half year in half a century with major indexes falling as much as 30% so far this year. Some high-flying tech stocks have lost between 70-80% of their value so far this year.
Fast rising inflation which the Fed Reserve is trying to counter with aggressive rate hikes has many believing that this could steer the economy into a recession. This has led to a blowout in the stock market as investors are dumping risky assets seeking haven in other assets.
However, selling stocks in reaction to a market plunge or a coming recession may be akin to throwing out the baby with the bath water. Some stocks are better equipped to handle the rout in a bear market and the headwinds from a recession.
Investing in dividend-paying stocks is a way investors can ride through a rocky market or economic period when capital gains are hard to achieve. This offers an insight into why dividend funds have added $43 billion in 2022 as of late June, according to research from SPDR Americas.
In this article, we look at how you can use dividend stocks to beat a bear market and recession.
There are several rules which are considered sacrosanct to investing in the stock market - one of which is 'Don't fight the Fed'. This much-touted mantra suggests you should align your choices with the actions of the Fed.
Aligning with the Fed suggests investing more aggressively when the Fed is lowering rates. Conversely, when the Fed raises rates, you'd be more conservative in your choices.
As such, why does it make sense to buy dividend-paying stocks when the Fed is raising rates at its fastest pace since 1994?
Dividend investing has been an effective long-term tool for insulating portfolios from sell-offs in a bear market or biting effects of a recession.
When we invest in stocks, two elements make up our return - stock price appreciation and dividend payouts. The key to fighting recessions comes from the latter.
Many companies are slow to cut dividends, providing some investors with reliable cash flow. Dividend aristocrats even have a history of increasing dividends annually, even during previous recessions.
As capital appreciation becomes scarce and investors sell stocks during recessions, dividends pick up the slack.
A steady cash return of 3 to 5% can go a long way to taper losses from stock price slumps and produce income in a period when money circulation is tight. Also, dividends when reinvested to take advantage of the power of compounding can help build wealth over time.
Dividend payers tend to be large, mature companies, producing products and services still needed all season, even during a recession.
There would be fewer people willing to splurge on a designer bag or Rolex watch. However, everyone still needs toilet paper or groceries. As a result, dividend-paying companies have established customer bases and relatively stable sales, earnings, and cash flow over time.
Because dividends are paid out of excess earnings, this means the company does not need these profits to grow the business - a silver lining in a period when other companies would be hoarding cash and cutting spending.
Another point worth noting is that many companies that pay dividend-paying companies often have fairly disciplined management teams with shareholder-friendly corporate cultures.
Management tends to balance the continued growth of the business with returning excess cash to investors. This is a contrast to a growth company that is massively reinvesting profits to grow the company. This may lead to layoff of workers as the company tries to cut operating costs.
Secondly, because the compensation of most growth companies is tied to stock options, it may lead management to take drastic actions to keep or sway shareholder attention on the stock when prices slump.
The key point is that during periods of economic uncertainty, having a disciplined management is important as this can make or mar the direction of the company and its stock price.
Regular dividends usually trade in the market with less volatility than stocks that don't pay dividends.
This 'boring' characteristic comes in handy during bear markets. Since World War II, the US stock market has experienced 11 recessions and bear markets. The average dividend cut during that period has been a measly 0.5%, compared to an average stock market decline of 32%.
Because dividend-paying companies are usually reluctant to cut dividends, even during a bear market or recession, this gives investors confidence that the dividend payments will continue indefinitely at the same amount or greater. This translates to lower trading on the stock and equally less volatility.
As seen from the current market rout, growth companies have been the epicenter of the sell-out in the market. Juxtapose this to the price action of value stocks that have witnessed less volatility.
Just because dividend-paying stocks may be a good way to ride a recession or bear market, this does not imply that all companies that pay dividends are a good choice for your portfolio.
Companies that produce essentials usually fare better than those that produce discretionary items whose lifeblood depends on spending/economic health.
As such, investing in utility, consumer staples, industrials or healthcare would likely be more profitable for your portfolio than investing in consumer discretionary or tech.
For example, a discretionary firm, such as Harley-Davidson (NYSE:HOG) or Macy's (NYSE:M) is far more likely to cut its dividend than a boring utility stock like Kinder Morgan (NYSE:KMI). The key is to focus on strength of the balance sheet and overall “quality” metrics like cash flows and margins.
Dividends are great tools to help fight recession and weather a bear market.
They can be a source of steady income for investors in a period when monetary circulation is tight. Less volatility on dividend stocks means fewer drawdowns on their stock prices, which can be a source of relief for investors in a market experiencing severe sell-offs.
Also because dividend-paying companies are more mature, with experienced management teams, investors are assured that the management can navigate the murky areas of a recession better than growth companies.
However, using the dividend toolbox to beat bear markets or recessions can vary in effectiveness.
Not all dividend-paying sector stocks can stem the tide of a market/economic downturn in the same way. Investing in dividend-paying companies that produce essentials produces far better results than investing in those that produce discretionary items.
In the end, by focusing on strong names, investors can actually get a portfolio that does its job during a downturn.
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