Wednesday, August 19, 2015

Are you ready for the next bear market?

It is not a secret that stock prices have been rising for 6 - 7 years in a row now. This makes it easy to hold on to stocks, and believe that we will have smooth sailing until we reach our goals and objectives.

In my investing, I do like to think about different scenarios. What if my quoted portfolio goes down by 50% in 2016?

I know a lot of investors who are focusing only on total returns would be unhappy. Imagine if you saved for 20 years, and accumulated a net worth of $1 million. Then boom – in one year, half of your net worth, blood,sweat and tears – gone. Would you panic?

I myself would likely be indifferent to a 50% stock price drop. As a dividend investor, I am somewhat insulated from stock price fluctuations. This is because I focus on the earnings power of the business, and the dividend payments that the businesses in my portfolio generates. It is very comforting to keep receiving cash, even when the quoted value of investments throughout the world is falling. When everyone else is hurting, I have the luxury of generating cash from my investments, which I can then deploy at ridiculously low valuations. As long as the underlying fundamentals of the businesses I own are intact, I can ignore stock price fluctuations. This is one of the most important traits of successful dividend investors. Those who do not understand that, are usually the ones that have not made any money in stocks to begin with.

Between 2007 and 2009, S&P 500 dropped a lot. I thought things were going down. It was scary to buy stock that would then go down 10% - 15% - 20% lower after each purchase. With the benefit of hindsight, you get all those people who are NOW telling us that they were buying. They probably did – but they weren’t around in 2008 and 2009, so I cannot verify that. Now stocks are up, and everyone is excited. For those who have no clue about investing, and are told to buy index funds, I am scared a lot. In theory, it makes sense to buy and hold for the long-term. But what does the future hold? Will the stock market go up, go down, or stay sideways? What if I retire right before a major bear market starts, which also coincides with inflation that decimates fixed income ( 1972 – 1974 US)? What if I retire right before a major bear market, but have no fixed income to protect me from deflation ( 1929 – 1932 US and 1990 – 2015 Japan)? What if I retire at a time when equity prices outperform, but are selling at insane valuations (US in 1997 – 2000). Will a new investor hold on patiently for the long run when they see the quoted value of their investments drop by 50%, or would they abandon their strategy?

It is helpful to look at history for guidance. You might enjoy reviewing the average duration of previous bear markets. You can see that every few years, there is a large double-digit drop. So you should be mentally ready when it comes. Learning from stock market history is important. The future will never repeat the past exactly the same way every time however.

The truth is however, I cannot predict stock prices. I cannot even predict whether the past will repeat in the future. Many assumptions are based on past, including the fact that stock prices will always go up, earnings will always go up, index funds always outperform in the long run and therefore it makes no sense to research investments. This is why I focus on dividends – this is cashflow deposited in my account, and I don’t have to sell. Dividends are more stable than capital gains, and are a direct link between company earnings and value. Thus dividends extract value out of an investment in stock – every quarter. Since prices are unpredictable, and vary a lot, I find strategies that rely on selling at regular intervals of time to fund expenses as particularly risky. Why are they risky? Because the market value of $1 in earnings could vary dramatically, based on the mood of Mr Market. However, the likelihood of a $1 in dividend staying as $1 or increasing is much higher in the grand scheme of things. Actually, index funds would likely work for someone who also owns bonds, and therefore withdraws 2% yield and 3% bond yield. If you have too much money anyways, chances are you are unlikely to ever run out of money. For ordinary DIY like myself, this is not an option. I want to use my assets efficiently, in order to generate the most income, with the least amount of risk, and the best prospects for future growth in earnings, growth and appreciation.

During the last recession, there were a lot of dividend cuts. However, among companies that had some track record of consistent dividend increases, the dividend cuts were concentrated in the financial sector. Companies like Coca-Cola (KO), Johnson & Johnson (JNJ) and AT&T (T) kept raising their dividends to shareholders. So did companies like Exxon Mobil (XOM). In the next crisis, it is possible that the wave of dividend cuts will be focused on the energy sector. However, I believe that the growth in other sectors will more than compensate the portfolio of the diversified dividend investor.

Of course, in order to succeed in investing one needs to follow those guiding principles pretty closely:
  • You want to avoid concentration
  • You want to avoid overpaying
  • And you want to build your portfolio slowly
  • You want to hold for 20 years
  • You want balance between price, growth, capital gains and dividends
  • You need to keep learning
With dividend growth investing I focus on companies which have managed to raise dividends for at least 10 years. This covers roughly 2 economic cycles. I do this to screen out companies that managed to grow dividends purely by accident, by being in the right place at the right time. Most of the companies in my portfolio that have ever cut dividends did not have a ten year streak of consecutive dividend increases.

I want companies that have an above average chance of maintaining earnings power when things get tough. Those are the companies that will keep paying and raising dividends during the next recession. Since I focus on underlying long-term business fundamentals, rather than the manic depressive stock market, this protects me from worrying about its crazy fluctuations. That way I am less likely to panic, when my stock prices go down, and stay down. Receiving cash dividends also serves as a positive reinforcement, making me much less likely to panic.

I also have flexibility, because I can sell if dividends are cut. I can buy an asset that can provide sustainable earnings and dividends in order to maintain income levels. I know that trees do not grow to the sky. If stock prices go up a lot from here, that’s fine too, because my dividend stocks will increase in price as they earn more. However, the link between earnings and stock values is never clear cut. Sometimes certain companies are viewed favorably, and sometimes they are viewed unfavorably. Oftentimes, a company could keep growing, yet its share price remains stagnant for years. Focusing on share prices in isolation, rather than in conjunction with valuation, and fundamentals is usually a mistake. I am patient enough in that I do not get worried if the stock price of my investment goes nowhere for several years. Others view this as heresy, since they have been taught that you need to compare your portfolio to a benchmark such as the S&P 500 every month. If you underperform in that month, this means you need to abandon your strategy. Lucky for me, I do not manage outside money, so I can think independently and stick to my guns through thick or thin.

If I sold any time someone viewed my investments unfavorably, I would have never been 70% on my way to FI by 2018 ( give or take an year). People who switch strategies frequently never really amount to much in investing.

I know that during the next bear market, my portfolio will keep generating dividends to live off of. I would not have to worry about stock price fluctuations. The main thing I need to do is focus on those companies which have business models that are built to last. This means evaluating exposure to cyclical components of the portfolio. This also means keeping a diversified amount of companies in my portfolio. How many – as many as possible of course. It all depends on situation – if you own 40 companies, it makes sense to initiate positions in 10 new stocks if the original ones are overvalued today. The original 40 might be great compounders, and great long-term holds, but adding money at inflated valuations is not smart risk management.

Is your portfolio ready for the next bear market? How worried are you about a 50% drop in stock prices on your goals and objectives?

Full Disclosure: Long XOM, KO, JNJ, T

Relevant Articles:

- How long does it take to manage a dividend portfolio?
Stress Testing Your Dividend Portfolio
Do not become a victim of fear in your dividend investing
The Biggest Investing Sin Exposed
My dividend crossover point

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