Friday, December 5, 2008

Dividends and The Great Depression

Many pundits are comparing the recent bear market declines in the major US indexes to the market action from the Great Depression. Some go as far as comparing the current market decline to the bursting of the Japanese stock and real estate bubbles in the early 1990s.

These comparisons are of course not fruitful as each bear market is different than the rest. The 1973-1974 bear market erased half the value of the Dow Industrials, but it took 2 years to do so. This two year decline was accompanied by an 18% increase in consumer prices.

The 1929-1932 bear market saw the Dow lose over 89% of its value from its September 1929 peak to its July 1932 low. During the length of this decline, consumer prices actually declined by 21 percent.

The 1987 crash was a brief 37% correction in the markets. Most participants were bearish on stocks, and predicted that this crash marked the start of another great depression. The market did bounce back however and proceeded to reach new highs by 1989.

Now we are being told that the 2008 bear market is destined to bring us to the next Great Depression, with stocks falling to further multi-decade lows. I do think however that stock prices should not matter a lot to long term investors at this moment.

Most technicians will probably mock me, by showing that had I used a particular indicator, I would have completely avoided the bear market decline by selling out everything in January 2008. Its funny how in this day and age of computers and widely available stock market data, people could create timing models that worked in the past, which would promise tremendous paper riches to anyone that follows the signals. Unfortunately however, the results from these signals were not revealed to us until the market reached its 11 year lows. Furthermore, most of these signals are prone to many whipsaw entries and exits, which result in small losses that coupled with commissions, could easily wipe out a sizeable amount of ones portfolio equity. In addition to that, markets never truly experience the same behaviors as it did in the over fitted data. Now there are some analysts that have called the current stock market top several months ago, but they don’t have a longer term track record behind them.

I believe that the main issue with the stock market declines is that investors hold stocks for the wrong reasons. One of the main reasons why investors held stocks for the majority of the 20th century was to collect stock dividends. It is true that markets could bounce up and down, and the speculative public will be ecstatic and then depressed about stock prices. But to the dividend investor, as long as he receives his dividends, the world is still a great place to be in. If you compared the annual dividend rates to the prices of major stock market indices, you would notice that dividends on aggregate experience less volatility than prices. If you are a retiree who lives off their portfolio, living off the dividends stream will expose you to less fluctuations in your investment income as compared to selling a portion of your portfolio each year for income.
During the 1920’s, annual dividends on the Dow Industrials ranged between 3.90 points in 1921 to 6 in 1927. In 1928 and 1929 annual dividends increased to 9.80 and 12.80 respectively. After that dividends did decrease to as low as 3.40 points in 1933. For those who bought all of their stocks in 1929 the decrease in dividend income would have been over 70%. In reality no one purchases their stocks in a lump sum. People usually use dollar cost averaging over a wide period of time in order to accumulate their nest egg. For those of our retirees whose last purchase occurred in 1927 the decrease in dividend income wasn’t as bad.

There is another issue about the portfolio of our Joe the Retiree- he wouldn’t have been 100% invested in the stock market. Even a small allocation to bonds of at least 25% would have smoothed out his/her income. However, if the whole country is in a shape like it were during the Great Depression, chances are most investment choices won’t make you a lot of money.
As I was doing my research on dividends during the great depression I found out that IBM, AT&T and Exxon kept their dividend payments stable. Others like Kellogg and Procter and Gamble didn’t maintain a stable payment.

An investor who was living off their portfolio in the 1973-1974 bear market would have seen their stock portfolios lose half of its value in a matter of two years. Their dividend income would have increased by 17%, which trailed inflation by about one percent. This time the bond portion would have been a drag on inflation adjusted income, despite the fact that it would have achieved better returns than stocks.

Although I do not believe that there is a perfect investment strategy, I think that creating a diversified dividend growth portfolio is the way to beat any bear market. Dividends have a lower annual volatility than stock prices and they tend to increase more than the rise in consumer prices over time, which creates an ideal inflation adjusted source of income. Furthermore, at least a small 25% allocation to fixed income would be helpful to retirees in smoothing their income and stock equity. I am ending this post with a quote from Warren Buffett, which seems very relevant to the subject of long-term investing for dividend income:

“I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years.”

Full Disclosure: I own shares of PG

This article was first posted on The Div-Net one week ago. It also appeared on Carnival of Personal Finance #182 - Don’t Go Broke Over The Holidays Edition.

Relevant Articles:

- Determining Withdrawal Rates Using Historical Data

- Average Durations of Previous Bear Markets

- Dividend Yields are rising

- Should you re-invest your dividends?

Popular Posts