You Must Remain Long Stocks

by: EB Investor

Markets continue to climb a wall of worry, and scared by 2008, many investors continue to sit on the sidelines in cash or "safe" bonds.

I expect stock prices to go higher from here, as several variables converge to create a Goldilocks environment for equity investors.

While concerns remain to certain economic variables, none pose a threat to this bull market at this time, and I remain long stocks.

When markets plunge, it is easy to get worried. Is this the beginning of something greater? If you are asking yourself this question, you are completely normal, and you are also suffering like most investors from a short-term speculator's mentality. In reality, investors need to rewire their minds to think differently about investing for the long run. This is all the more true for young investors. When stocks go down, that means stocks are on sale; your dollar now buys more of each stock or fund you are investing in. Embrace it, don't fear it. For young investors who are not going to need the money they are putting away for retirement for 30-40 years, this is all the more true. "Stay the course" is often-repeated advice, but it is very challenging for most investors to do.

"Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves." -Peter Lynch

In this piece, I want to explore first my case for why we are in a bull market that could last for years. Despite moves to the downside that we have seen this past week, I continue to believe that equity securities are the place to be. I also want to address how to invest going forward in this bull market and why following the research is so important for the long-run returns of your portfolio. Let me begin by making the case for why I remain bullish on America, and in fact, bullish on the world.

Bullish on America... Bullish on the World

This bull market is a great example of why you simply cannot time the market. Many investors have been sitting on the sidelines waiting for the inevitable drop in risk assets that will allow fresh cash to be put to work, buying equities at lower levels, but it has been elusive. Please stop trying to predict what is going to happen in this bull market; your crystal ball will likely prove cloudy. Investors are failing to realize we are in uncharted territory. Never before have we seen the major central banks of the world engage in experimental monetary policy on such a large scale. This has pushed the investors of the developed world out on the risk curve seeking to get some level of return for those who are invested. Bonds continue to sport negative or excessively low yields in much of the developed world offering investors negative real returns. There is no doubt equity markets have seen a substantial run since the financial crisis, but I believe there remains significant opportunity around the world for continued growth.

Despite the massive run-up, many investors remain in cash. We are not seeing broad participation in this historic bull market, more on this later. I do believe, as is usually the case, that we will not see the market enter euphoria until we get more of a broad participation from the retail investor. These two factors are not considered by most and will add to the case for why I believe this bull market can continue for some time.

Additionally, one cannot ignore the tax plan, which will be significantly beneficial for corporations and the economy. While I believe, on the individual side, it is less certain what the benefit will be, on the corporate side, I do believe you are going to see a material increase in the earnings of corporations, driven by good fundamentals and aided by less taxation paid out by corporations.

Understanding the Two Phases of the Bull Market

The recent rise in stocks has been significant, but we need to put it into context. First, we have to understand that bull markets do not die of old age. Second, we have to remember that the 2008 crisis brought stocks to obscenely low levels. Much of the market's rise has been merely bringing stocks back to reasonable levels given their underlying value. The fact that you could buy a quality bank like BNY Mellon (BK) for a mere $18 at the March 2009 low was obscene, given its book value was much higher.

In reality, this bull could run for many more years, with simple sector rotation and single stock corrections along the way. We could start the recovery all over again if we get continued structural reforms that are needed from Washington. Tax reform was the first in reforms that the market expected; further investments in infrastructure and reform to various other issues would be welcomed by the market. The president's State of the Union speech clearly laid out an agenda that will be pursuing these ends.

In his recent paper, "Can We Start the Recovery All Over Again?" which appeared in the American Economic Review, Dr. John Taylor (Stanford) discusses the need for structural reforms as the cure to the nations and the economies' challenges, stating:

Under current economic conditions, more permanent reforms would likely have large short-run effects to go along with their sustained growth effects. They would also help to counteract any short-run depressing effects which may develop in the economy and add a degree of stability. The unusual recent swing down in labor productivity growth, along with the unusually low contribution from capital services, suggests that it could turn up again if boosted by reform-induced incentives. Similarly, the large drop in labor force participation, along with evidence that it is not all demographics, suggests that it too would revert with reforms. Thus, policy reforms would not only raise the long-run growth rate of the economy, they would also likely bring an extra boost to growth in the short run, much as in a normal recovery from a recession when growth surges at first before settling into an expansionary mode. Since the economy missed that surge in this recovery, in effect we would be restarting the recovery all over again. (Taylor, 2016)

I believe the prospects for U.S. corporate earnings, and thus equity securities, have increased under the effects of comprehensive tax reform that affects both businesses and individuals. Large increases in corporate earnings, as a result of a reduction in tax rates, will allow corporations to distribute more earnings to their shareholders. Additionally, a repatriation of cash from overseas may result in a flurry of one-time dividends or increases in share buybacks. In short, these are all positive catalysts for stocks going forward that will drive this bull market higher. So, it stands to reason that if investors should stay long this bull market, where should they be investing?

First off, you cannot time the market, so don't wait for a further pullback. The time to invest, assuming you are a long-term investor, is when you have the money to invest. In terms of where to put it, I like to invest in strategies that bring out the quality (profitability), value, and size factors discovered by Fama and French to lead to above-average returns over long measurement periods.

This means holding a broadly diversified portfolio of securities that skew the portfolio towards value, quality, and smaller-cap stocks. Over the long run, this will, according to academic research, produce superior investment returns. When we discuss quality stocks and value stocks, we tend to be talking about companies that have the ability to grow their dividends over time, or companies that have paid dividends for a long period of time. In short, dividends matter when building a high-quality investment portfolio for the long run.

The Return Advantage of High-Quality Dividend Stocks

It is important that investors approach the work of constructing a portfolio with risk and return in mind. To this end, I believe, and the research proves, that the core of an investor's portfolio should be high-quality, dividend-focused equity securities. Dividend-focused investing is an important strategy for anyone wanting to build a core of high-quality stocks for the long run. Research clearly demonstrates that dividends have produced the bulk of the return from equity investments over long time periods.

In their text, Triumph of the Optimists: 101 Years of Global Investment Returns, authors Dimson, Marsh, and Staunton (2002) examined the composition of asset returns in both the U.S. and U.K. market from 1900 to 2000. Their research found that long-term returns were driven by reinvested dividends. In fact, the return from reinvested dividends was 85 times that of a portfolio consisting of capital appreciation alone. The chart below demonstrates its findings:

Figure 11-2 shows the equivalent UK returns both with and without dividend reinvestment. With dividends reinvested (the green line), an investment of £1 made at start-1900 in the UK stock market would have grown to £16,160 by the end of 2000. By coincidence, this is very close to the terminal wealth of $16,797 from a $1 investment in the US market. Since UK inflation was higher than US inflation, the United Kingdom had an annualized real return of 5.8 percent compared with 6.7 percent in the United States. If dividends had been spent rather than reinvested, the UK investment of £1 would have grown to just £149 (the red line), a nominal return of 5.1 percent. Over the same period, UK consumer prices rose 55-fold, so this corresponds to a real capital gain of 1 percent per year, compared with 2 percent real in the United States. The longer the investment horizon, the more important is dividend income. For the seriously long-term investor, the value of a portfolio corresponds closely to the present value of dividends. The present value of the (eventual) capital appreciation dwindles greatly in significance. The analysis above shows why, throughout this book, we have stressed the importance of dividends in computing total returns. (Pg 151)

Additional research by Robert Arnott of Research Affiliates further proves the importance of dividends to long-term investment returns. In a 2003 editorial in the Financial Analysts Journal, titled "Dividends and the Three Dwarfs," Arnott explored the returns of equity securities for 200 years, ending in 2002. He found that dividends were the most important component of return. Of the total annualized return for the period of 7.9%, 5.0% of that was from dividends, 1.4% from inflation, 0.6% from rising valuation levels, and 0.8% from real growth in dividends. He states:

The importance of dividends for providing wealth to investors is self-evident. Dividends not only dwarf inflation, growth, and changing valuation levels individually, but they also dwarf the combined importance of inflation, growth, and changing valuation levels. This result is wildly at odds with conventional wisdom, which suggests that, while the return from bonds is wholly dependent on income, stocks provide growth first and income second. It is startling to realize that dividend growth has averaged less than 1 percent above inflation during the past 200-year period. And it is shocking that real per-share dividend and earnings growth on the S&P 500 Index since 1965 has been zero.

He ends: "Dividends, unequivocally, matter."

In a further global study of equity returns, titled "The Importance of Dividend Yields in Country Selection," in the Journal of Portfolio Management, A. Michael Keppler studied the relationship between a firm's dividend yield and its overall return. He found that an investment in the highest-yielding quartile produced the best investment return overall:

This is further demonstrated in Triumph of the Optimists: 101 Years of Global Investment Returns. In the 10th Chapter, the authors show the cumulative returns from 1926 to 2000 of U.S. stocks that rank each year in the highest or lowest-yielding 30% of companies. They found that higher yielding stocks outperformed their low yielding counterparts, 12.2% to 10.4% respectively, demonstrating again the importance of dividends:

Often-cited Wharton School Professor Jeremy Siegel wrote a book titled The Future for Investors. In this text, he ranks the components of the S&P 500 by dividend yield, for the time period 1957-2002. He found that the highest-yielding stocks beat their lowest-yielding counterparts and the S&P 500 index:

The research presented here is only a sample of the many research studies that prove that dividends unequivocally matter over long time periods. Thus, investors seeking to design a portfolio for the second phase of this bull market would be wise to favor value stocks from around the world that have a history of raising their dividends over time. This shows financial strength and could lead to better investment returns over a full market cycle.

Dividend Investing Around The World

There is no doubt that in a rising rate environment, dividend stocks, especially high dividend yield stocks, are at risk of correcting, especially after nearly a decade of outstanding returns. The S&P Dividend ETF (SDY), which is a basket of companies that have raised their dividends every year for at least 20 years, is up 410% since the March 2009 low, turning a $10,000 investment into $51,116, so investors' concerns are well taken.

However, the key to long-term investing is to stay the course and have a globally diversified portfolio. Dividend-focused companies overseas are trading at a fraction of their domestic U.S. counterparts, offering investors enormous value. iShares International Select Dividend (IDV), for example, trades at a P/E of 14.06 and a P/S ratio of only 0.54 vs. 20.56 and 1.68, respectively for SDY. International companies offer investors tremendous value in the dividend space, yet far too many investors leave them out of their portfolio altogether. I believe this is a mistake.

The core of an investor's portfolio should be made up of high-quality equity securities from around the world. Whether you choose to hold a Total World Index (VT) as your core, or a combination of U.S. and international dividend payers, is up to you, but I believe the global synchronous uptick in growth will lead to an increasingly positive picture for earnings growth and thus stock prices going forward. Investors should construct the core of their portfolio to be high-quality and global in nature to ensure they capture their fair share of stock returns that will result from this growth pattern.

Many have criticized dividend investing as being simply a weaker form of value investing. To a degree, this is true. It is important to note that a company's dividend or history of dividend payments is only one of a multitude of criteria that should be considered by investors. Surely, most dividend strategies tend to be value-focused strategies as well, which is why strategies that combine value and quality tend to result in higher total returns over the long run. Where I would disagree with this criticism is when we are talking about deep value strategies that reduce overall quality and introduce additional risk into the portfolio model. Regardless of where you come down on the issue, including value and high-quality stocks are important components to a well-diversified long-term strategy.


I remain bullish on America for the long run. There is no doubting what is happening in our country and in our economy. As the most dynamic economy anywhere in the world, we continue to be a leader in innovation and discovery. As a long-term bull on America, I naturally believe that investors should be holding long-term allocations to equity securities that reflect the triumph of the optimists. However, what makes this growth phase all the more advantageous for investors is that the world seems to be growing together. This synchronous growth pattern creates an opportunity for investors to take advantage of the continuing prosperity of businesses through a portfolio of globally diversified securities. Despite recent weakness, the long-term trend remains.

I do not believe that in the current environment, it is advantageous for investors to hold bonds. This view conforms with the vast majority of financial thought leaders, from Charles Ellis to Burton Malkiel. I continue to believe in this not as just a short-term environmental, cyclical philosophy, but rather as a structural belief. Over the long run, the optimists triumph, and thus equity securities remain the main driver of wealth creation for most investors. Bonds do nothing more than manage behavior. In this environment, it is far better to hold a basket of high-quality equity securities from around the world that can take advantage of this global synchronous growth pattern that will push stocks higher. While the U.S. remains further along, value still remains. Investors would be wise at this point in the cycle to hold a value-focused strategy to take advantage of the second half of this bull market cycle.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is for informational purposes only and is not an offer to buy or sell any security. It is not intended to be financial advice, and it is not financial advice. Before acting on any information contained herein, be sure to consult your own financial advisor. This article does not constitute tax advice. Every investor should consult their tax advisor or CPA before acting on any information contained herein.