Are Dividend Stocks the Best Path to Income in a Bear Market?

Capital preservation is paramount for investors nearing or in retirement, so it’s a focus for financial advisors as well. Large drawdowns during a bear market can affect savers’ ability to retire comfortably. For some investors, portfolio declines may mean postponing retirement plans or even returning to work.

Traditionally, one source of income for retirees has been dividend stocks. But let’s say an investor owns a stock that’s down significantly but still pays a dividend. Ford Motor Co. (F) is a good example: The stock has declined 25.3% this year as of August 1. Its 12-month trailing dividend yield is 2.6%. Sure, some return is better than none, but you’re making up only a fraction of the difference between the stock’s former and current valuation.

That is causing some financial advisors to rethink their approach to dividend investing. Others are continuing to use dividend payers as part of a strategy to outpace the broader market.

The road to stability for client portfolios in a bear market doesn’t have to be a dividend-stocks-only route. Read on for more strategies used by financial advisors to generate income and returns for clients during challenging economic environments:

— Consistent dividend payers.

— How to think about options.

— Another way to preserve capital.

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Consistent Dividend Payers

“My firm has been using a dividend strategy this year and beating the broad indexes with it,” says Jonathan Howard, financial planner at SeaCure Advisors in Lexington, Kentucky. “It’s been our most successful investment strategy this year by far.”

For portfolios in general, Howard says, dividends act as a buffer against losses. Of course, that’s assuming a higher yield and lower losses than a single stock like Ford would have provided year to date.

“If the dividend yield of a portfolio is 4% and the prices of the holdings are down 10% over a year, the total return is -6%,” Howard says. “The dividends help to soften the impact of economic downturns.”

Another important factor for investors: Companies that pay out consistent, reliable dividends tend to be large value companies. “Their books are good, and their stock prices are trading below where they should be based on fundamentals,” Howard says.

This year, these large-cap value companies have not taken nearly the beating that the overall market has. That’s true even when you compare these value stocks to the Barclays U.S. Aggregate Enhanced Yield Index, generally considered a proxy for the U.S. bond market.

John Robinson, founder of Nest Egg Guru in Honolulu, takes a combination approach to boost client portfolios in a bear market. He uses individual certificates of deposit as well as Treasuries for the fixed-income portion of client portfolios. He also uses index fund ETFs, or exchange-traded funds, for the equity portion, particularly in retirement accounts.

“Outside of retirement accounts, I often help clients develop passive income streams by investing in companies that increase their dividends each year at a rate that is higher than inflation,” he says.

Robinson explains to clients that this strategy has nothing to do with stock picking, but is instead a way of screening for companies that are healthy enough not just to pay dividends, but to increase these payments each year by at least 5% to 7%.

“Importantly, dividend yield is not a primary screening criterion,” he says. “High dividend yields often signal slow dividend growth or potential dividend cuts. These days, 2% to 4% yields are the norms for the companies that meet our other screening criteria.”

Other criteria Robinson screens for include:

— Price-to-earnings ratio under 20 times earnings.

— Dividend payout ratio of 50% or lower (except for utilities).

— Five-year average dividend growth rate of 5% or more.

He will sell a stock if a company cuts its dividend or if it has three consecutive years of falling earnings and revenue.

How to Think About Options

Howard also uses covered-call options strategies to generate income. “However, the income will be taxed as ordinary income due to the holding period rules on options income,” Howard says. “While a diversified, reliable dividend portfolio may generate dividends in the 3% to 5% range consistently, covered-call portfolios can generate income in the 7% to 12% range.”

Investors can use that higher income to offset the extra taxes, Howard says.

Not all Howard’s clients initially take to the idea of options, but he takes the time to explain the strategy using an illustration that they may be more familiar with. “My experience is that a lot of people simply get spooked by the newness of the idea and the complexity of it,” he says.

“Our firm likes to look at it like you’re renting out your stocks the way you would investment real estate,” he explains. “Someone is paying you for the right to maybe buy your stock someday in the same way you’d get rental income from a tenant in an apartment building.”

Another Way to Preserve Capital

Another somewhat controversial approach to generating return during a bear market involves using inverse ETFs, which are designed to move in the opposite direction from their underlying benchmark. For example, the ProShares Short S&P500 ETF (SH) provides inverse exposure to the S&P 500 index.

“I am a fan of using inverse ETFs to add some downside protection to stock portfolios, especially when someone owns a lot of low-basis stocks with large, unrealized gains that they don’t want to sell,” says Jordan Kahn, chief investment officer at HCR Wealth Advisors in Los Angeles.

This strategy can help lower an investor’s overall exposure to the market and add a hedge to portfolios, he says.

However, Kahn cautions against using leveraged inverse ETFs, which return two or three times the inverse of their index. “Stay away from the leveraged ETFs. They have quirky pricing mechanisms that can result in large tracking errors versus the underlying indexes they are shorting,” he says. “Also, I would consider them as an alternative strategy, but not necessarily a dividend replacement, since they don’t provide any dividend income.”

Kahn says the current market demands a different approach from the one investors used in the market meltdown from 2007 through 2009.

“Bear market rules apply. That means tighter risk management for starters, and always using stop-losses to protect capital when you’re wrong,” he says.

He adds that investors should also be comfortable holding higher cash balances than normal, while patiently waiting for a more durable market bottom.

“The last 13 years have been buoyed by quantitative easing, ultra-accommodative monetary policy and very low inflation,” Kahn says. “The environment today is basically the exact opposite. So stock picking becomes more important, as does paying attention to valuations. Get back to basics. Stock picking isn’t meant to be easy, but it can be done if you put in the work.”

More from U.S. News

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Are Dividend Stocks the Best Path to Income in a Bear Market? originally appeared on usnews.com

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