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How Dividend Payers Can Protect Against a Downturn

Josh Peters, CFA

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Stocks have been off to a rocky start in 2014 after an outstanding 2013, but does this mean that we're on the verge of a correction, and should dividend investors be worried about it? I'm here with Josh Peters, editor of Morningstar DividendInvestor and also our director of equity-income strategy, to take a closer look.

Josh, thanks for joining me today.

Josh Peters: Good to be here, Jeremy.

Glaser: What's your opinion on where we are in the economic cycle? Is this bull market pretty much on its last legs? Are we looking at potentially the economy slowing down significantly, or do you think that we're more in the middle of this cycle?

Peters: I really try not to base my investment strategy around the idea that I have to correctly ascertain where we are in a cycle or the next cycle turn, but looking overall, I kind of feel like we're in the middle innings. This is a nine-inning ballgame typically, an economic expansion and a bull market. We are definitely well out of the first inning.

You think back to how this bull market started, how the economy started to recover back in 2009, you had a lot of things that were really working in our favor. Coiled springs, you might say. Stock prices were very low. Valuations were very low. Profits were low too, but they were poised to come back if the economy at some point came back, which it did. So you've seen excellent returns since that point, about a triple actually in terms of total return with reinvested dividends for the S&P 500 since that bottom in March 2009.

Now, profits are at record levels again. P/E ratios look kind of normal relative to the last 25 or 30 years, but there's not a lot of upside potential I think from here, unless you want to start predicting a big speculative bull phase that maybe we would be better off not having. But then again, usually you get your big bear markets and crashes in conjunction with some kind of a recession, and I don't really see a lot of the economic imbalances you would expect to trigger a recession have really had time to build up yet.

In my DividendInvestor cover story, I [used the ballgame analogy, saying] we may be in the middle innings. That doesn't mean that the game might not go into extra innings; it doesn't mean that the game might not be called early on account of rain. But I think the key takeaway here is that you want to shape your thinking as if perhaps we're in the middle or maybe closer to the end than the beginning at this point. You don't want to be stuck way out there in terms of risk.

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Glaser: If most of those easy gains have been reached and we saw those big multiple expansions through 2013, does that leave equity investors at risk in 2014? Would you expect a correction to be a possibility then?

Peters: We can have a correction any time. Here since the beginning of the year, stocks are down a little over 3%, using the S&P 500 as a yardstick. That's still a ways to go on the downside to reach the classic definition of a correction being a 10% pullback. Maybe you won't get that far. There's some bad news that is out there that people weren’t previously incorporating into stock valuations; now that discounting process has begun. I don't expect a repeat of last year. But then again, I didn't have a real strong expectation at the beginning of last year that we were going to see total returns in the low-30% range. Instead, I think you have to shift the conversation. You have to organize your portfolio and your thinking around what is going to matter most for a retirement strategy, whether you're leading up to retirement, saving and investing for retirement, or whether you are already there making portfolio withdrawals. And that's your income.

Is your income coming in as you expected? Is it reliable? Do you have stocks that maybe are poised to cut their dividends and you need to take some action? Is your income growing as fast as you expected?

It's kind of curious. Last year we had such high returns for the market overall, far in excess of what just dividend yield and dividend growth would explain for the market, but dividend yield and dividend growth were good, especially in our portfolios, the fact that we had well-above-average yields to begin with as well as dividend growth that's above our long-term targets.

So I'm willing to let prices kind of fluctuate up and down and around that central line, that being the income that my portfolios throw off.

Glaser: What would you say to an investor who maybe is a little bit more worried than you who thinks that we could be, if not on the verge of a recession, at least see continued slow growth, that there could be some big changes in stock market valuations with the way stocks are currently valued. How could they prepare? How should they think about their dividend portfolios?

Peters: I think you've got two choices. One is to play the game that just about everybody plays, which is when is the next recession coming? How bad is it going to be? Which stocks are going to fare the worst, et cetera, et cetera. That's a really, really tough game to play. If people could see recessions coming, maybe we wouldn't have them. Or if enough people saw them coming, then we would all be millionaires by selling all our stocks and going short. Real life just doesn't work that way. I made point this month that I have a 0% success rate.

We had a giant recession in 2008, 2009. I didn't see it coming. To my credit, I didn't predict a bunch of recessions that didn't actually happen. I just didn't make any predictions at all. But even though I didn't know what the economy was going to do, I was inclined to just go ahead and admit that and say, "What stocks do I buy today or continue to hold today if the recession starts tomorrow?" And that in turn should govern how you think about your portfolio and what kind of stocks you want.

In 2013, a lot of the food stocks and utilities, those classic defensive names with the big dividend yields, they underperformed. They lagged on the upside, but they do very, very well relative to the market on the downside. And then they don't have that much pain to recover from.

I think it's actually better to just maintain that defensive stance in all environments. It makes it easier to own your stocks when the market is going down and you don't want to be a seller. It may not be quite as much fun on the upside, but again, it's very hard to determine and predict those speculative and cyclical turns in the market. Just why not maintain that defensive stance all the time? That's been a strategy that's worked very, very well for the DividendInvestor portfolios over the last nine years.

Glaser: It sounds like there's a reasonable chance that there could be a correction at any time, that investors shouldn't be panicking or overly worried about it and should stick to that conservative strategy?

Peters: Yes, stick with your strategy. And if your strategy is oriented around trying to time the market or time cyclical shifts in the economy, don't start now. Just stick with good companies that will do well, hold up, pay their dividends, and maybe even raise them even during those recessions.

Glaser: Josh, thanks for your thoughts today.

Peters: Thank you too, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.

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