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Grin and bear it

Paul Sullivan

 

If you're anything like me, every time the market dips these days, you think it's the beginning of the end of the nice bull market run we've been enjoying for, oh, the last seven years. Then the market rallies and once again, the Dow sets a new record high.

I'm not sure how much more of this I can stand, but it beats the alternative - that sickening, grinding drive to the bottom. But as unbearable as they are, market corrections are distressing cyclical and predictable.

Adam Hamilton, one of the CPAs writing at the Zeal newsletter, predicts: “The bottom line is the odds are rising that we are indeed in the eve of a new cyclical bear. If this particular specimen follows precedent, the Dow 30 could fall 50 per cent or so over the coming two or three years.” He says that prudent and careful investors and speculators will thrive, but those caught unaware will be “utterly slaughtered. Bears are brutal and unforgiving times to enter the markets armed with anything less than the best knowledge and research.”

I don't pretend to be an expert, and I'm always cautious about the bears - they dwell too much on the obvious - that it's tough to make money - and not enough time on what to do next. Mr. Hamilton above is a great example. A recent 3,000 plus essay, Eve of a Bear, is 3089 words long and here's exactly how many he spends on what to do: “As paper assets are relentlessly shredded in these ugly events, real assets like commodities tend to shine.” That's it! Well, he does toss in a remark about half way though that during the 1973 and 1974 cyclical bear, gold tripled over the exact period of time that the stock bear ran. And elite gold miners' stocks followed gold up on balance over this period of time, not the general stocks down. But that's it - nothing on gold's relationship to energy, supply, etc. Historically, however, gold is a good bet during a bear run.

The problem with gold is volatility. You could spend every day of the bear on the seat of your pants - when will the market rally and gold stocks lose their shine? No, bear markets last about two years, and that's too long to, uh bear. You need a strategy, other than putting your money in the ground and watering it daily, that will get you through the cycle and stay strong when the market recovers.

So here's an idea - I don't take credit for it - it comes from “The Wizard of Wharton”, professor of finance Jeremy Siegel. His investment plan is based on finding dividend paying stocks, then reinvesting the dividends.

And in a bear market, when investors are selling almost indiscriminately, dividend-paying stocks are easier to find.

Siegel is the author of a couple of well-regarded books on income investment, such as Stocks for the Long Run (hailed by the Washington Post as one of the 10 best investment books of all time) and The Future of Investors (which was named one of the best of 2005 by Business Week, Barron's and the Financial Times).

Siegel brings comfort to investors in a bear market. He calls dividend-paying stocks “bear-market protectors” and “return accelerators”. The dividend yield (the dividend per share divided by the price) goes up when the stock price goes down, if the dividend stays the same.

Then, you re-invest the dividends into more of those dividend-paying stocks that are now low-priced stocks thanks to the usual indiscriminate buying that happens when the markets start to dive. Your new shares are the “bear-market protector” and when the markets turn positive again, they become your “return accelerators”. The new shares protect you against the stock's loss of value even if they never get back to full value, because you've got more of them, and they're still paying dividends. And now that you have more of these little gold mines, if the price does recover, your payoff is better, because you've got more of them.

Like all great professors, Siegel knows his history. His research shows that on September 3, 1929, the Dow hit 381 and didn't revisit that number again until November, 1954! If investors were able to ride out the wave during that 25-year-period, they would have been ahead by 6 per cent, and that's during the Great Depression.

We may not be on the brink of great depressions, but sunny old Adam Hamilton consults his charts and graphs and divines that the markets could drop by as much as 60 per cent over the next two years:

“Our current cyclical bull achieved a massive 75 per cent run compared to 57 per cent in the last Great Bear, or 1.3x. If we get a roughly symmetrical cyclical bear, it could hence conceivably grow to 1.3x the 45 per cent loss in 1973 and 1974. That works out to a 59 per cent decline! Yikes. Coincidentally that would carry us down to 5250, right near half fair-value levels at 7.0x earnings. While I suspect a 60% decline is far less probable than a 45% decline, it is still possible.”

That's Mr. Hamilton's “Yikes” by the way.

But the bottom line here is that it doesn't really matter if tomorrow is a good day for the bulls or the bears, according to Siegel. This strategy works across all market conditions. If you invested $1000 in Merck (NYSE: MRK) in 1957, for example, which has a dividend yield of 2.37 per cent, you would have enjoyed a 15.9 per cent rate of return over the ensuing 25 years and in 2003, you'd be sitting on $1,003,410.

Of course, when you're looking for dividend-bearing stocks, there are a couple of things to look out for:

Ok, so if this is so easy, why doesn't everyone do it? Because it's boring. Because companies with high dividend yields don't make the news. I mean, would you ever seriously thing about buying stock in Snap-On Tools (NYSE:SNA)? Yet, it's up almost 60 per cent in the last two years, and it has a dividend yield of 2.3 per cent. Snap it up; sit back and grin at the bear.

Paul Sullivan is a longtime Vancouver journalist and president of Sullivan Media. He also writes for The Globe and Mail.

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