Hello everyone! I hope you’ve made it through this admittedly stressful week feeling good about your lives and your portfolio. The macro sell-off that we’ve seen in the broader markets continued this week, with the Nasdaq falling into correction territory (down 10% from its prior highs) and the S&P 500 nearing that threshold as well, down approximately 9.5% from its highs. And yet, in this piece, I will discuss why it is that this does not scare me.
I admit, there are legitimate headwinds facing markets these days…
The Fed has plans to turn hawkish and there is do doubt that the end of easy money policies and rising rates could hurt economic growth and therefore, cause the stock market to sell off further. It certainly doesn’t have to be that way. The Federal Reserve could thread the needle perfectly, with regard to the tight window that it has to taper and raise rates just enough to fight off inflation, but not enough to cause growth to crumble. It’s a delicate balance for sure, and ultimately, investors must trust that the Fed is full of some of the brightest economic minds in the world and assuming that their decisions allow them to achieve their mandates (with regard to inflation and employment) that strong economic figures will follow.
And speaking of a delicate balance, I’m seeing reports left and right that war is imminent in Europe, which is definitely a justifiable cause of fear. We haven’t seen large scale military conflict on the European continent since World War II and any comparisons to that period of time are going to cause all but the most bullish investors to consider selling shares and running for the hills.
Lastly, the Omicron variant continues to wreak havoc on society, the economy, and most importantly, the supply chain. With that being said, inflation is likely to stick around longer than most expected, which isn’t good for the economy (or the bottom lines of the companies that we follow in the stock market). Furthermore, ongoing pandemic fatigue is weighing heavily on the minds of investors and I think negative headlines associated with the seemingly never ending nature of COIVD-19 is certainly factoring into the bearish shift that we’ve seen in the markets.
And this bit about COVID-19 is a perfect segue into an apology from me…
I typically try to get these Durable Dividends articles sent out on Saturday around lunch time, which means that every week I carve out time within my content slate on Saturday morning to write the weekly article for you all. Well, when I woke up yesterday morning, I discovered a toddler with an extremely runny nose and a hoarse cough, which was a problem, because we had plans for a birthday celebration with my wife’s 80+ year old grandparents this weekend.
Prior to the pandemic, a runny nose on a toddler would have been no big deal. Kids get sick all of the time. It’s unpreventable. However, these days, a runny nose meant that I had to run around town in search of a COVID test, which, unfortunately, was to no avail because everyone was sold out of over the counter tests, meaning that I ultimately ended up at the offices of my local pediatric associates.
Needless to say, my work schedule on Saturday was destroyed by this COVID-related inconvenience, but thankfully, that’s all it was: an inconvenience, because the tests came back negative.
I know that for millions of families across the world, the COVID-19 virus has been much, much more than a hassle. It has led to the loss of loved ones and devastated lives. Therefore, I am extremely blessed that my daughter was not sick with the potentially serious disease and that we were able to visit my wife’s elderly grandparents safely, due to the fact that their immune systems are likely less vigorous than my 2-year old’s.
With that personal narrative out of the way, we’ll transition into another personal narrative which is related to the markets (and more specifically, the sell-off that we’re seeing)…
In recent days, I’ve seen a lot of investors fretting about what to do with their holdings and their cash in the midst of the negative volatility that we’re seeing.
While I’m not a financial adviser and therefore, I’m not in the position to provide individuals with a direct plan of action for dealing with bear market scenarios, I am happy to talk about the system that I’ve put into place which allows me to sleep well at night during periods of abnormally high market volatility.
First of all, I want to note that owning the blue chip dividend growth stocks that I imagine most dividend growth investors follow/own provides peace of mind in itself.
While it’s true that no dividend is ever 100% safe, the fact of the matter is, when I look at the fundamentals associated with all of my holdings, I wholeheartedly expect to see them not only maintain their dividends, but continue to raise them, moving forward throughout 2022.
Yes, things could change fundamentally which would make my dividends less secure.
There is always the chance for a black swan event which totally disrupts the market and the economy.
However, the vast majority of my current holdings made it through the 2020 pandemic period unscathed (from a dividend cut standpoint) – right now, the only stock that I own which cut its dividend during 2020 is Disney (DIS) – and therefore, I don’t expect to see any bearish event occur in the short-term which is more disruptive to the earnings potential of my holdings than the COVID-19 pandemic, which is essentially a once in a 100-year type of event, play out in the near-term.
This means that during a bear market, I expect to have a constant stream of dividends rolling in which will provide me with dry powder to put to work, buying shares of blue chip companies into weakness.
This provides the foundation for my market related solace. It’s nice to know that the compounding process that my portfolio strategy is based upon will continue, via dividend re-investment, throughout a potential bear market.
What’s more, my household’s current income stream means that I will have money available to invest on a monthly basis throughout a recessionary period, assuming that neither of us loses our jobs.
So long as I have disposable income available, I plan to continue to make disciplined monthly purchases, which also means that I’m taking steps, regardless of what the macro economy is going, to accelerate the rate at which my passive income stream compounds.
Both my wife and I work in relatively high demand fields, so I don’t see this happening; however, once again, I acknowledge that no employment situation is 100% safe and therefore, I’ve always believed that it is important to maintain a bear market cash pool which ensures that I have resources to put to work during a major market sell-off.
The downside to holding cash within a dividend growth portfolio is that it does not factor into the positive compounding situation created by re-invested reliably increasing dividends. On the contrary, cash is a depreciating asset over time (especially in today’s high inflationary environment). Therefore, I know many dividend growth investors who choose to avoid cash holdings all together, instead, favoring a 100% allocation towards equities which allows their passive income stream to compound at the maximum rate.
For those that are able to stomach that sort of risk (equities are risk assets, afterall), that’s great. Over the long-term, equities tend to move higher and as I’ve said many times before, I believe that time in the market is more important than attempting to time the market, from the long-term investors’ perspective. Therefore, maintaining overweight equity exposure to U.S. markets has worked well in the past and while I don’t have a crystal ball to say whether or not this strategy will work well into the future, I’m in the Warren Buffett camp when it comes to never placing bets against the strength and resilience of the U.S. economy and stock market.
However, even with this long-term bullish mindset in mind, this all-in all the time strategy when it comes to equities doesn’t mesh well with my personal risk threshold.
I don’t think that I would be able to sleep well at night if I didn’t have a defensive cash buffer on hand. And this is the first important point that I want to make…
There is no perfect universal formula for cash holdings within the dividend growth strategy.
I think that cash is a wonderful tool to provide peace of mind and limit irrational mistakes (when we’re fearful in the markets, we tend to do things that we will later regret). But, the amount of cash that provides peace of mind (balancing the flexibility it provides to take advantage of downturns with the dividend growth investors’ desire to use it to generate reliably increasing passive income) will vary from individual to individual.
To me, a high single digit cash allocation is where I generally feel comfortable. Right now, I have a ~7% cash position. The vast majority of this cash is earmarked for bear market events (meaning, that I’m not willing to dip into it unil the S&P 500 has fallen more than 10% from its 52-week high).
Truth be told, nothing that I say in this article is likely to prove to be revolutionary, in terms of asset management. Actually, my plan is rather elementary. But, the important thing is: I have a plan.
As the old saying goes, “An ounce of prevention is worth a pound of cure.”
This saying is attributed to Benjamin Franklin, who was talking about fire prevention in Philadelphia nearly 300 years ago. But, I think the same idea…which says that preparation can save a lot of hardship, holds true in the stock market as well.
So many investors end up getting caught off guard by poor asset allocation decisions during negative volatility and become forced sellers of high quality assets.
Then, oftentimes, the fear that inspired those investors to sell doesn’t allow them to aggressively buy back into market weakness. Many times, those forced sellers end up hoarding the cash that they’ve raised and only put it back to work once market sentiment shifts, a rally occurs, and FOMO (the Fear of Missing Out) takes over.
In other words…they sell low and buy high, which, as I’ve said many times, is exactly the opposite of what investors ought to be doing.
I always want to be in a situation where I can buy low without having to part ways with the shares of wonderful companies that I’ve accumulated over the years. This is especially the case when we’re talking about a potentially deep sell-off that creates wonderful (and rare) buying opportunities. And therefore, I’m content to hold cash, especially when the market is rallying towards all-time highs.
I don’t want to find myself in a situation where I’m seeing wonderful bargains left and right because of a bear market, but I don’t have the means to capitalize on the rare discounts that bear markets provide.
And therefore, when it comes to my bear market cash, I use a laddered approach to dipping my toes into a market sell-off.
My simple plan is this: I break my bear market cash up into evenly weighted segments, which I plan to put to use, buying the highest quality companies that I can find which are trading with attractive discounts to fair value (during bear markets, I tend to focus on quality, as opposed to deep value, because of the relatively defensive dividends that they provide) when the S&P 500 hits certain negative thresholds: -10%, -15%, -20%, -25%, -30%, -35%, and -40%.
Historically speaking, sell-offs that are deeper than -40% are exceedingly rare and therefore, I don’t think the risk/reward of planning for events much worse than that makes sense.
In the event that a major sell-off occurs and the market dips lower than that, I’ll be out of dry powder and have to rely on monthly savings and dividend income to buy the deepest discounts. But, I’m okay with that.
But, knowing that I will have cash coming into the market during each negative leg of a potential sell-off ensures that I will be able to buy the wonderful bargains that pop up throughout a market sell-off. This measured approach protects me from impulse to act too quickly and ultimately, missing out on better bargains down the road.
With all of this being said…hopefully you have a plan in place on how to take advantage of the market’s weakness, especially if it accelerates to the downside.
Remember, as share prices fall, dividend yields rise. And, if you’re like me and generating passive income with your investments is your main priority, share price weakness in the short-term can actually be a good thing, when we’re talking about long-term financial goals and accelerating the journey towards financial freedom.
I’ll end this article with another Franklin quote, from Poor Richard’s Almanac, “Haste makes waste.”
In other words, rushing into a situation – any situation…but especially those related to the stock market – can be dangerous and result in a poor outcome.
Therefore, while I know it’s exciting for bargain hunters to finally see attractive value after a year of relatively low volatility bullish momentum, I caution investors against greedy behavior (remember, greed is just as destructive to wealth creation as fear).
I witnessed many investors blow through their cash reserves very early in the March 2020 sell-off and express regret that they didn’t have cash to buy the once-in-a decade type of deals that came up towards the end of March two years ago.
Having a plan to capitalize on a bear market helps to ensure that investors not only avoid fear and therefore, take advantage of the discounted share prices, but that they also avoid greed and make sure that their cash position can last throughout the duration of a bear market event.
This article is intended to provide information to interested parties. As we have no knowledge of individual circumstances, goals and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks mentioned or recommended. It does not guarantee that securities mentioned in this newsletter will produce profits or that they will equal past performance. Additionally, we are not an investment advisor and do not offer securities or tax advice. Although all content is derived from data believed to be reliable, accuracy cannot be guaranteed. Nicholas Ward, contributors and staff members of Wide Moat Research may hold positions in some or all of the stocks listed.
Nicholas Ward is a research analyst who currently writes for Seeking Alpha, The Dividend Kings, iREIT, and Forbes Real Estate Investor. Before that, he was Founder and Editor-in-Chief of The Dividend Growth Club, as well as the Income Minded Millennial. Nicholas has also contributed to Sure Dividend, Investing Daily, and The Street, where he covered stocks in Jim Cramer's Action Alerts PLUS Portfolio.
Nicholas holds a bachelor of arts from The University of Virginia, where he studied English and studio art. Prior to transitioning into the financial industry, he managed a vineyard in the foothills of the Blue Ridge Mountains.
