With low returns likely for years ahead, dividends become critical. Here's a new spin on my dividend portfolio, along with 3 new plays, writes MoneyShow's Jim Jubak, also of Jubak's Picks.
Wouldn't you know it?
Just when dividend investing is becoming more important—the key stock market strategy for the current market environment, in my opinion—it's also getting to be more difficult to execute.
That's because shifting tax rates and special dividends in December 2012 have distorted the reported yield on many stocks.
I think there's only one real choice: Investors have to pull up their socks and work even harder at their dividend investing strategy. That's why with today's column, I'm revamping the format of the Dividend Income portfolio I've run on the Jubak's Pick website (and its precursor on MSN Money and MoneyShow.com) since October 2009.
The changes aren't to the basic strategy. That's worked well, I think, and I'll give you some numbers later on, so you can judge for yourself and think about putting my approach to work.
The changes are instead designed to do two things:
To let you and me track the performance of the portfolio more comprehensively, and more easily compare it with the performance turned in by other strategies.
To generate a bigger and more-frequent roster of dividend picks so that readers, especially readers who suddenly have a need to put more money to work in a dividend strategy, have more dividend choices to consider.
In this column, I'm first going to give you a brief explanation of why I think dividend investing is so important right now. I'm even going to argue that dividend investing might be the single best strategy for this market environment. (And that's an important argument, in my opinion, since I think this market environment is going to persist for years.)
I'll then lay out the changes in how I'm going to track this portfolio going forward and give you some numbers so you can judge the performance of this portfolio since 2009, and particularly in 2012.
Finally, I'm going to give you a pick to replace one stock in the current portfolio that has been a disappointment, as well as two new picks-that's three picks in all-as part of an expanded dividend portfolio.
Why Dividends are Critical
So why is dividend investing so important right now?
For the last nine months or more, I've been writing about what I've called the "new paranormal" market. If you've missed the foundation of this argument, see my post from March 2012, Call it the new paranormal market. My argument is that we've entered a period of relatively low returns.
Bill Gross, the bond guru at Pimco, calls the current environment the "new normal." He believes that we'll be lucky to see average annual returns of 5% a year during this period, which could stretch out for a decade. In my model for the "paranormal market," I've added a wrinkle to Gross' model: Not only will average annual returns be low by the standards of the great bull market that governed the 1980s and 1990s, but markets will also be extraordinarily volatile.
So, yes, you might see an average annual return of 5%, but that average will include years of 10% or 15% drops in addition to substantial rallies, and the period will include years like 2011, when the market will produce half a dozen swings of 7% or more in a month, as it did that August. The challenge will be to stay in through the volatility. You need to avoid buying high in moments of market optimism and selling low when everything seems to be headed for ruin-or better yet, find a way to sell more often at market highs and buy more often at market lows.
Why Things Really are Different
Why do I believe that there's any validity to either Gross' "new normal" or my "new paranormal" market?
I'm skeptical of attempts to argue for long-term market trends while we're in the midst of the action. What seems like a trend can easily turn out to be just a part of a longer data series pointing in a very different direction. So I'm reluctant to say that just because average returns have been so "modest" and so volatile lately, they must continue that way for some future period. Consider the cumulative return on the Standard & Poor's 500 Index (SPX), which is 13.4% for 2012, 27.9% for the last three years-and -2.87% for the past five years.
What I find convincing about the "new normal" and the "new paranormal" models is the match between the market performance data and the underlying fundamentals of the global financial system. In the last decade or more, we've seen long-term trends-the integration of more countries into the global economy, the rise of new economic powers, big changes in the location of global cash balances and in the direction of global cash flows (as emerging economies emerged and developed economies aged and slowed)-that have challenged that system.
And while the global financial system has survived, by and large, the cost has been huge actions and reactions by the world's central banks that have sent waves of cash sloshing across the world. That has led to massive market bubbles created by the overshoot of central bank policies (cheap money and the technology boom and bust, cheap money and the real estate boom and bust, cheap money and the global financial crisis).
The period has combined falling real returns, as globalization has increased competitive pressures on bottom lines and as aging populations have stressed global retirement systems, with rising volatility, as ever-expanding central bank balance sheets have led to cycles of booms and crashes. The strongest argument for a period of "new normal" or "new paranormal" returns: The trends that have pushed down returns on capital (globalization and aging) continue to work-and central banks now face the challenge of supporting the global economy with new cash infusions even as they confront huge balances that require them to exit these markets.
I'd love to see any logic that holds that this is a recipe for steady positive returns.
Why is dividend investing so important in this environment? I've laid out the reasons elsewhere, but let me restate them here. Volatility will create repeated opportunities to capture yields of 5%-the "new normal" and "new paranormal" target rate of return-or more as stock prices fall in the newest panic. By using that 5% dividend yield as a target for buys (and sells), dividend investors will avoid the worst of buying high (yields won't justify the buy) and selling low (yields will argue that this is a time to buy). And unlike bond payouts, which are fixed, stock dividends can rise with time, giving investors some protection against inflation.
The challenge in dividend investing during this period comes from using dividend yield as a guide to buying and selling without becoming totally and exclusively focused on yield. As I argued in my last update to this portfolio on July 3, what continues to matter most is total return. A 5% yield can get wiped out very easily by a relatively small drop in share price. (For more on that argument, see this post at JubakPicks.com.)