As demonstrated by its price movement over the last decade, the stock market goes through long-term periods when stock prices experience very little if any price appreciation. Referred to as secular bear markets, these stagnant market periods can last more than 15 years. Since the current secular bear market likely began in 2000, it's possible we'll see a few more years of market sluggishness. So what can you do while you wait?
One option is to invest in high-yield dividend-paying stocks. Investing in stocks that provide a stable dividend at an attractive yield can be an effective investment strategy during a secular bear market. In fact, the Dow Jones Select Dividend Index, which is screened annually to contain high-yield stocks with stable dividends, had a positive total return of 34% for the nine years ending March 31, 2009. During that same period, the S&P 500 index lost 37.4%.
Dividends are cash distributions that companies make to shareholders (usually on a quarterly basis) that represent a portion of company earnings. Dividends can increase as the underlying business grows, but keep in mind they can also decrease or be cut during challenging economic times.
While often overlooked in the secular bull market of the 1980s and 1990s, the cash return that many stocks offer should not be taken lightly. Dividends and dividend re-investments have had a material impact on wealth creation over time.
According to a leading authority on asset allocation, one dollar invested in large company stock at year-end 1925, with dividends reinvested, grew to $2,049 by year-end 2008 (a compound annual growth rate of 9.6%). However, if dividends were removed from the equation, and the stock value was solely based on capital appreciation, that same dollar would only be worth $71 at the end of 2008 (a compound annual growth rate of 5.3%).1
Dividends can provide significant advantages to investors that become even more prominent during bear markets. Here's why:
This is a key advantage over non-dividend-paying stocks. This cash return is received even during down or flat markets. Shareholders can use this cash payment any way they want — reinvest it in additional shares (perhaps the most appealing option considering the potential for significant future returns), apply it toward a different investment, save it or spend it.
The recent market pullback has provided dividend yields not seen for several years, which are very attractive compared to current interest rates. The compounding effect of even a couple percentage points will have material impact on total return over the long haul.
A dependable dividend provides support for a stock because, no matter what is happening in the stock market, investors will eventually jump in to buy if the yield is attractive enough. So in market corrections, demand for consistent dividend payers increases as investors move toward safety, while demand for speculative stocks usually decreases. This price support, coupled with the cash return the dividend provides, can soften the impact of market downturns.
While it might not seem like it right now, both the market and the economy will eventually recover and grow again. When stock prices are depressed, cash dividends can be reinvested into a greater number of shares, which can create a dollar-cost-averaging effect. This can materially enhance returns during market recoveries.
Historically, many companies have increased their dividend payments over time. In fact, several companies have increased dividends to shareholders for 30 or more consecutive years. This is one of the main differences between stocks and fixed-income investments, such as bonds, and a key benefit when economic conditions improve. As a result, stocks are not as impacted by changes in interest rates and can act as a hedge against inflation.
With today's low interest rates on cash investments and reduced returns on other asset classes, it's easy to see why many investors are turning to dividend-paying stocks to provide them with attractive yield and capital gain potential. But it's also important to note that dividend-paying stocks are not the be-all and end-all of any investment strategy — every portfolio needs to include a variety of investment types to help reduce exposure to risk. To find out if dividend-paying stocks are appropriate for your portfolio, talk to your financial advisor.