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After a punishing start to May, the markets look to be turning around … at least for yesterday and today. Is the pain over? Is the market a buy, sell or hold?

Before I get to the actual stock-specific recommendations, we need to discuss where the market is at. Portfolio Café founder, Tim Fortier, recommended a 30% NASDAQ hedge to all his clients in addition to a VIX volatility hedge a few weeks ago. That was good advice. But is it time to drop the hedge and buy up cheap stocks?

My opinion is no. A few short days of relief buying does not warrant a change of broader sentiment. If this rally shot up another 2.5% or more followed by a shallow test on support - we may have a case for removing hedges. But a couple days of up-action often traps bulls that only exacerbates the next wave of shorting and selling. Extreme caution is necessary right now.

What would I recommend doing in this market? First, your small-cap stocks should have experienced a nice pop. I believe that it is time to take some risk off the table and roll these into safer stocks. And what might those be? I have one strategy that I would like to recommend…

Dividend Aristocrats With a Twist

Most dividend growth investors are familiar with the Dividend Aristocrat index which tracks blue chip companies with increasing dividends over the past 25 years. The green line is the Aristocrat ETF and the red line is the S&P 500 ETF (SPY). Not a huge amount of excess gain if you ask me.


(Click to enlarge)

While this is a good sound stock universe to choose from, this strategy is lacking is valuation and timing. When do you buy specific stocks and why? All we know about these companies are that they have a certain management policy to increase dividends and have historically had the capacity to do so. We know nothing about when the stocks might have the best valuations or when an upswing might be due.

To enhance this dividend growth strategy I choose the top yielding stocks which may give us better valuations. Next, I use a 'revert to the mean' filter which selects stocks with yields well above their historical average in the hopes that prices are depressed. This leaves anywhere from 15 to 25 companies from the index of 51. Finally, I run a basic fundamental ranking filter that scans for such things as book value, earnings and revenue to select the highest ranked 10. From here, I buy and rebalance every 3 months and stay invested at all times.

The chart below shows the trailing 11 year gains using such an approach (total return). Including dividends (but not taxes, slippage, or transaction fees) this system earns 17.71% annually.
(Click to enlarge)

But are we trading illiquid and high-risk stocks? Hardly. Look at the names that come up on today's scan that I recommend buying right now:

Ticker

Name

(XOM)

Exxon Mobil Corporation

(AFL)

AFLAC Incorporated

(WAG)

Walgreen Company

(ABT)

Abbott Laboratories

(EMR)

Emerson Electric Co.

(ADP)

Automatic Data Processing

(MCD)

McDonald's Corporation

(SYY)

SYSCO Corporation

(NUE)

Nucor Corporation

(PBI)

Pitney Bowes Inc.

Adding a Hedge

Notice that this system is 100% invested at all times. Do you want to smooth volatility? Then I recommend following a market timing system (the one we use at Portfolio Café tracks S&P 500 estimated earnings trends with index price confirmation) and add a 20% hedge with a 2x leverage inverse S&P 500 ETF when the market turns down. The chart below shows how volatility is smoothed in the blue areas when the hedge kicks in.

Chart compliments of Portfolio123:

While annualized gain only climbs a mere 2%, this small hedge reduces drawdown to a maximum of 12% while the rest of the market fell over 4 times that hard.

The Bottom Line

The markets are teeter-tottering on the edge of another leg down. While it is impossible to forecast with any surety what the market will do next, I feel there is enough risk to warrant a strong recommendation towards this modified Dividend Aristocrat strategy with a hedge. If the market continues to climb and forms a new uptrend - you only need to remove the hedge. If the market drops, you'll still be able to sleep at night without worrying about your kids college fund.

Source: High-Yielding Dividend Growth Strategy For Any Market