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Income as Correction Protection

Readers of this column know that I am expecting a stock market correction. And it could be soon, once enough investors realize that many of the anticipated economic benefits from President Trump’s pro-growth legislative agenda are unlikely to materialize later this year, if ever.

So it is fair to ask; why have any money in the stock market if it is about to decline 10% – 20%, as I have predicted?

The answer to that question goes straight to the nature of a stock market correction versus a crash. Unlike a crash, which drags down almost all stocks by a similarly large amount, a correction is less severe in magnitude and does not punish all stocks equally. That’s because corrections are triggered by a specific event that implicates a clearly definable group of vulnerable stocks, while a crash is the result of across-the-board panic selling that does not discriminate between companies or sectors.

For that reason we employ proprietary stock rating models such as IDEAL and SHIELD to manage our Growth and Income portfolios, which help us screen out companies that appear overvalued and likely to suffer the most during a correction.

At the same time, high-quality stocks with strong dividend yields can benefit from corrections as the long-term security of their revenue models is embraced by disaffected investors who realize that companies that pay high dividends are able to do so because they have strong balance sheets and positive cash flow.

Investors who obsess over the vagaries of Federal Reserve policy are missing the point. Regardless of the monetary and political climate, it always makes sense for income investors to seek companies with a long history of paying and growing dividends.

From Darlings to… Goats

Trendy stocks such as Netflix (NSDQ: NFLX) and Tesla (NSDQ: TSLA) may be Wall Street’s darlings while the market is on a tear, but their sky-high valuations and non-existent dividend payments can work against them when their fair-weather shareholders run for the exits. The same popular stocks that have doubled in value for no apparent reason can just as easily drop by half when the momentum that has been driving them upward dissolves.

However, companies with a track record of increasing dividend payments attract a different type of investor, one that sticks with them through up and down markets. Institutional investors such as pension funds favor reliable dividend payers because they know that over half of the stock market’s long-term return is attributable to dividends. They view corrections as opportunities to add to positions at discounted prices, not as a reason to bail out of the market.

That’s why all of the Personal Finance recommended portfolios throw off an average annual dividend yield above that of the 10-year Treasury note’s recent 2.2% annual interest payment. I don’t believe it makes much sense to own a 10-year T-note since it offers no growth potential at all. Of course, you are assured of getting the full face value of the note back at maturity, something no stock or mutual fund can promise.

But that peace of mind comes at a big price. Since the end of the World War II, the S&P 500 Index has produced a positive return over 92% of all 63 rolling 10-year periods, and outperformed the T-note’s present 2.2% “guaranteed return” 81% of the time. The average total return for the index over all those periods is 103%, more than four times the cumulative 10-year return of 24% available on the T-note at its current yield.

Each of our portfolios is managed to achieve a specific objective, but all of them place a high value on dividends. As you might expect, our Growth Portfolio places more emphasis on share price appreciation than dividend income to achieve total return. For that reason, it has the lowest average yield at 2.5%, but that is still higher than the yield on the 10-year Treasury note.

The Income Portfolio also is managed from a total return perspective but puts a greater emphasis on dividends. Its average yield of 4.5% is more than twice that of the T-note, and more than 50% greater than the 2.8% yield offered by the 30-year Treasury bond. Our Fund Portfolio splits the difference with an average yield of 3.7%, reflecting its diversification across a wide array of growth and income holdings.

As its name suggests, the Maximum Income for Retirees portfolio has only one objective — high current cash flow — and delivers it with an average yield of 8.1%. At that level of income, this portfolio could lose 7% of its share price value every year for the next 10 years and still deliver a higher total return than the Treasury note!

How you choose to manage downside risk in your investment portfolio is entirely up to you. For my money, owning stocks that pay solid dividends is one of the best ways to avoid getting soaked the next time the stock market goes through the wringer.

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