A 5% Income Strategy For Bull Markets And Bear Markets

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Includes: AOS, ARCC, BBN, BLK, D, ENB, GBDC, HD, HQH, ITW, JNJ, JPC, K, KYN, LMT, LOW, MAIN, MDT, MMM, MMP, MO, NLY, NRZ, O, OHI, OXY, PCI, PRU, QCOM, QQQX, RFI, SPY, STAG, STK, STOR, T, TGT, TLT, TROW, TXN, UPS, UTF, VTR, WBA, WPC, XOM
by: Financially Free Investor
Summary

The stock market has been very jittery and volatile since last month, and the future direction remains unclear. However, it has recovered some of the losses since then.

The fear factor remains high due to concerns about the unknowns on the escalation of trade disputes on multiple fronts.

Irrespective of a bull market or a bear market, we present a four-pronged all-season portfolio strategy to generate 5% income, lower risks, and smaller draw-downs.

It was barely a month ago when it looked like everything was rosy. The economy and the GDP were humming along nicely with record high employment. Everyone believed that the US-China trade deal was almost a done deal. The steel and aluminum tariffs on Canada and Mexico were done away with. Even the Fed had moved from a hawkish stand to a dovish one. The stock market was aiming for new highs, and many so-called experts had started talking about a stock market melt up. That’s when the dream got shattered. The trade disputes on multiple fronts have suddenly taken center stage. Markets have now realized that trade deal with China may not even happen in 2019 (or 2020) and tariff war between the two countries will only escalate for now. On top of that, we have news about new tariffs on Mexico, which has the potential to derail the USMCA (new NAFTA) deal.

[Update: June 8, 2019]: According to the latest news and President Trump’s tweet, the Mexico tariffs have been suspended indefinitely for now, and the US and Mexico have some kind of agreement to avert the proposed tariffs.

With so much negative sentiment in the market, it's surprising that the stock market only lost about 7% from the recent peak, and it has been recovering in the last few sessions. However, the sentiment is still bearish, which may actually be the silver lining for a bull market to emerge. We have no special insight to know the future market direction. If we have to make a guess, we think the markets will muddle along until the next earnings season.

All that said, fortunately, to be successful in investing, we do not need to know the future market direction. Besides, in spite of all the challenges, there are no recessionary pressures on the horizon, at least yet. The recent turmoil in the stock market has actually brought the stretched valuations for many stocks, especially in the technology sector in check.

Markets will always go through their usual ups and downs, have small as well as big corrections from time to time, which we have no control over. But that should not discourage us from investing. What we need to do is to make a well thought out plan based on our own goals and risk tolerance and implement the plan systematically.

As investors, ideally, we want to capture the majority of the gains of the bull market but would like to avoid any major losses during corrections and/or recessionary periods. This is, of course, easier said than done because it's very difficult to know when those key moments arrive.

If you are an index investor, it's almost impossible to avoid major corrections. You ride to the top as well as to the bottom along with the broader market. A vast majority of the folks find it emotionally very difficult to cope with major losses and sometimes bail out just at the wrong time.

Moreover, if you are nearing retirement (or already retired), a big correction, early in the retirement, can be devastating. A 30% correction will require 43% gains in the future just to erase the losses, whereas a 50% correction would need 100% gain to get even. In retirement, one needs to have a portfolio that's income centric so that one does not have to worry and stress about the market's gyrations.

The Multi-Basket Investment Approach

The best way to prepare for any kind of market, whether it's a bull market, bear market or a sideways market, is to follow some sort of systematic multi-basket approach. None of the plans or strategies can be perfect, so it may be best to have multiple strategies. We believe when one strategy zigs, some other one will zag. Convert your portfolio into at least three baskets (or buckets). Each basket should have unique goals and objectives. We are going to present one such portfolio of four baskets for conservative investors or retired folks.

Let's assume for the sake of illustration, that our "Total Investment Capital [TIC]" is $1 million.

Portfolio type

Suggested Range (% of TIC)

Allocation followed in this article

Basket-A

DGI Portfolio

30-40% of the TIC

40% of the TIC

Basket- B

Risk-Adjusted (2-Securities) Income Portfolio

25-30% of the TIC

30% of the TIC

Basket- C

High-Yield Portfolio

20-25% of the TIC

20% of the ITC

Basket- D*

Cash, Gold or Cash-like securities (For conservative investors and retirees)

10-20% of the TIC

10% of the TIC

*Allocation to the last basket could vary, for example, it would be different for a younger investor when compared to a 65-year old retiree. This cash-like bucket may not be needed by younger investors. Instead, they should use this bucket as a high-growth bucket. However, more conservative investors could allocate as much as 15% or 20% of the TIC.

Subsequent to the formation of baskets, you should preferably write a "plan-of-action" for each basket. Since the nature of each basket is different, so will be the plan-of-action. Obviously, the plan-of-action for each Bucket would be different.

Sample Portfolios for First Three Baskets

You could structure the above three baskets in a variety of ways based on your personal preferences, goals, and risk tolerance. However, just to provide a starting point, we will provide sample portfolios for each of the three baskets.

Basket A: DGI Basket - Dividend Income

The best way to structure a dividend-income portfolio is to select stocks of 20-30 large, blue-chip companies that have a history of paying and raising dividends year after year. This should make the foundation or "Core" of our investments. Just like the foundation of a house, the foundation of our Portfolio needs to be strong. You should choose the strongest stocks from each sector, which are available at a fair price.

Goals and Selection Criteria:

  • Minimum 20-25 companies that are large-cap, blue-chip names with a sizable moat in their respective industries. Initial bucket capital to be allocated equally to each stock. However, on an ongoing basis, a stock position should be trimmed if the position size exceeds 10% of the bucket.
  • Dividend yield to be greater than that of the S&P 500, but preferably over 3%. The average yield of the portfolio to be at least 3.5%.
  • Yearly dividend growth of above 5% or Chowder-number to be at least 8. However, some companies may have a higher initial yield with lower dividend growth.
  • Smaller drawdowns than the broader market during past corrections.
  • Should have at least raised the dividends in the previous 10 years. For this reason, we will consider only Dividend Champions or Dividend Contenders from the CCC-list currently maintained by Justin Law (originally created by David Fish).
  • Not more than three or four names from the same sector. At least one company from each sector/industry segment. Within a sector, companies should be from different industry segments.
  • Reasonable valuation.
  • This bucket is by and large a buy-and-hold bucket. We will rarely sell anything unless the fundamentals of a company change significantly, or the dividend is no longer sustainable, or the position size exceeds 10% (in that case trim, not sell).

We present (see below) a sample DGI portfolio consisting of 25 names, a majority of which are relatively conservative names, provide a decent dividend and trading at relatively cheap valuations. If you are putting new capital into the portfolio, we recommend buying in multiple lots spread over, maybe a year. This will avoid a situation where the market has a major correction just after you buy.

The average dividend yield of this sample portfolio is 4.01%, and dividend growth over the past five years and 10 years have been 11.82% and 12.16%. The average Chowder-number for this portfolio is impressive at 15.83.

List of 25 DGI Stocks:

Name

Symbol

Sector

Div-growth No of years

Div Yield

DGR 1-yr

DGR 3-yr

DGR 5-yr

DGR 10-yr

Market Cap ($Mil)

Debt/ Equity

Chowder Rule

AT&T Inc.

(T)

Communication Services

35

6.67

2.0

2.1

2.1

2.3

223,630

0.95

8.8

Target Corp.

(TGT)

Consumer Discretionary/Retail

51

3.18

3.3

5.3

9.8

15.4

41,830

1.00

13.0

Lowe's Companies

(LOW)

Consumer Discretionary/ Sp Retail

56

2.06

17.1

20.4

21.2

18.4

74,530

4.45

23.3

Home Depot Inc.

(HD)

Consumer Discretionary/Sp Retail

10

2.87

15.7

20.4

21.4

16.4

211,870

n/a

24.3

Walgreens Boots Alliance Inc.

(WBA)

Consumer Staples/ Pharma, Retail

43

3.57

8.4

6.4

7.3

15.0

44,970

0.73

10.9

Kellogg Company

(K)

Consumer Staples/ Food products

15

4.26

3.8

3.6

4.1

5.4

18,060

3.67

8.4

Altria Group Inc.

(MO)

Consumer Staples/ Tobacco

49

6.52

14.9

10.4

9.7

9.5

92,510

2.07

16.2

Occidental Petroleum

(OXY)

Energy/ Oil & Gas

15

6.27

1.3

1.7

5.4

10.2

37,270

0.49

11.7

Exxon Mobil Corp.

(XOM)

Energy/ Energy Major

37

4.92

5.6

3.9

5.6

7.6

302,190

0.21

10.5

Magellan Midstream Partners LP

(MMP)

Energy (partnership)

19

6.54

7.7

9.2

12.6

10.8

14,060

1.64

19.1

Enbridge Inc.

(ENB)

Energy

23

5.92

11.4

12.2

10.9

12.8

73,620

1.05

16.8

BlackRock Inc.

(BLK)

Financials/ Cap markets

10

3.18

20.2

11.3

12.3

14.4

63,940

0.16

15.5

T. Rowe Price Group

(TROW)

Financials/ Cap markets

33

3.01

22.8

10.4

13.0

11.3

23,700

0.00

16.0

Prudential Financial Inc.

(PRU)

Financials/ Insurance

11

4.33

20.0

13.8

15.8

20.0

37,800

0.40

20.1

Medtronic plc

(MDT)

Health Care/ Equipment

41

2.16

7.9

11.9

12.2

11.9

124,320

0.50

14.4

Johnson & Johnson

(JNJ)

Health Care/ Pharmaceuticals

57

2.90

6.6

6.3

6.4

7.0

350,570

0.50

9.3

Lockheed Martin

(LMT)

Industrials/ Aerospace, Defense

16

2.60

9.9

10.1

11.4

16.2

96,010

5.65

14.0

United Parcel Service, Inc.

(UPS)

Industrials/ Air Freight, Logistics

10

4.13

9.6

7.6

8.0

7.3

80,250

6.68

12.1

A.O. Smith Corp.

(AOS)

Industrials/

25

2.17

35.7

26.0

27.0

19.9

6,720

0.16

29.2

3M Company

(MMM)

Industrials/ Conglomerates

61

3.61

15.7

9.9

16.5

10.5

91,960

1.69

20.1

Illinois Tool Works

(ITW)

Industrials/ Machinery

44

2.86

22.3

18.5

16.4

11.3

45,670

2.42

19.3

Qualcomm Inc.

(QCOM)

Information Technology

16

3.71

8.5

9.3

13.3

14.6

83,740

4.24

17.0

Texas Instruments

(TXN)

Information Technology

15

2.95

24.1

23.4

19.7

20.4

98,580

0.68

22.7

W.P. Carey Inc.

(WPC)

Real Estate

22

4.97

1.2

2.1

5.1

7.7

14,030

0.87

10.0

Dominion Energy Inc.

(D)

Utilities

16

4.88

10.0

8.8

8.2

7.8

60,580

1.57

13.1

Average

29

4.01

12.23

10.60

11.82

12.16

92496.40

15.83

Basket B: Risk-Adjusted, 6% Income and Capital Preservation Basket

Goals:

  • Preserve capital during big corrections or recessionary periods.
  • Smaller maximum drawdowns, possibly no more than 15%-20%.
  • Nearly 5-6% Income.
  • Total-returns over any 10-year rolling period > 10%.

This basket can be formed in many ways, from very simple and easy to implement strategies to some complex ones. However, here, we will provide an example of a very simple and easy-to-implement strategy:

A Simplified 6% Income Portfolio:

This is one of our most simplified 6% income strategies. We are trying to achieve simplicity without compromising much on the income or the total returns. This is still a monthly rotation risk-adjusted portfolio but invests in only one of the two securities at any given time. At the end of each month, we will look back at the performance of the two securities over the previous three months period and select the security which has performed better.

Below are the two securities for this portfolio, invested in only one of them at a time:

Nuveen Nasdaq 100 Dynamic Overwrite Fund (QQQX)

Nuveen Nasdaq 100 Dynamic Overwrite Fund is a closed-ended equity indexed fund. It invests in the public equity markets of the United States, mainly in the stocks from the Nasdaq 100 Index. The fund also invests through index call options. It seeks to replicate the performance of its portfolio against the Nasdaq 100 Index. Nuveen Nasdaq 100 Dynamic Overwrite Fund was incepted on January 30, 2007.

The fund does not use leverage and pays a very decent distribution (quarterly) of 7.43%.

In a sense, we have chosen QQQX as a proxy for Nasdaq 100, but with a difference of high income. Since the distribution is on a quarterly basis, we won’t catch the distribution every time but will be able to do so quite often.

iShares 20-Year Treasury Bond ETF (TLT)

This ETF tracks the investment results of the ICE U.S. Treasury 20+ Year Bond Index.

The fund generally invests at least 95% of its assets in U.S. government bonds. The underlying index measures the performance of public obligations of the U.S. Treasury that have a remaining maturity greater than twenty years.

We will present the back-testing results (based on an initial investment of $100,000) from the year 2008-2019, which includes at least one bear market of the 2008-2009 financial crisis. Below is the performance of the portfolio in comparison to the S&P 500 Index:

Performance of Income Portfolio Vs. S&P 500:

Performance of Income Portfolio Vs. S&P 500, with 6% Withdrawal:

Below is the chart that shows how balances from the two portfolios would be impacted if we were to withdraw 6% income, increased by 2.5% inflation each subsequent year. Since the S&P 500 had highly negative returns in 2008, it would never get a chance to recover if the investor was withdrawing income.

Below is a chart showing how the portfolio was invested over the years.

Out of a total of 138 months of test-period, the QQQX-TLT portfolio was invested in QQQX for 82 months and for 56 months in TLT.

Basket C: High-Yield Basket

Goals:

  • 8% Income from distributions.
  • ~10% Total-returns over any 10 year period.

Now, many folks may question the appropriateness of a high-yield portfolio for a conservative investor. However, we believe that there is a place for a high yield bucket if used with the right proportions, something like 20% of the overall portfolio. The main advantage of a high-yield bucket would be that it would boost the overall dividend yield by adding a little risk. It definitely has more risk than our other buckets. But with proper allocation and staggered buying, the risk can be minimized. We will structure this high-income bucket with three types of securities, namely REITs including mortgage REITs, BDCs (business development companies), and some CEFs.

Security Type

Symbol

Name

Yield %

(06-05-2019)

BDCs/mREIT

ARCC

Ares Capital Corporation ( ARCC)

9.11%

MAIN

Main Street Capital Corporation ( MAIN)

6.21%

NLY

Annaly Capital Management ( NLY)

11.89%

GBDC

Golub Capital BDC ( GBDC)

7.30%

NRZ

New Residential Investment ( NRZ)

13.11%

REIT

O

Realty Income Corp ( O)

3.87%

OHI

Omega Healthcare Investors ( OHI)

7.41%

STAG

STAG Industrial ( STAG)

4.90%

STOR

STORE Capital Corporation ( STOR)

3.96%

VTR

Ventas, Inc ( VTR)

4.93%

CEFs

RFI

Cohen & Steers Tot Ret Realty ( RFI)

6.97%

UTF

Cohen & Steers Infrastructure ( UTF)

7.66%

BBN

BlackRock Taxable Muni Bond ( BBN)

6.02%

KYN

Kayne Anderson MLP ( KYN)

9.49%

HQH

Tekla Healthcare Investors ( HQH)

9.38%

PCI

PIMCO Dynamic Credit Income ( PCI)

8.20%

JPC

Nuveen Pref & Income Fund ( JPC)

7.83%

STK

Columbia Seligman Premium Tech ( STK)

9.18%

Total/ Average

8.08%

What Can We Expect from the Multi-Basket Portfolio?

The stock market has done very well for the past 10 years. If you were simply invested in S&P 500 (SPY) for all these 10 years, you would have done very well. But the market does not move in the linear fashion, and the next 10 years could be and would be a lot different than the past 10 years. In the 2008-2009 financial crisis, the S&P 500 index ( SPY) lost slightly more than 50%, from top to bottom. So, for most regular investors, and especially for retirees, it was very painful to see their savings reduced to half. Based on our past experience of how different securities behaved during the 2008-2009 crisis, we can estimate to see how our above baskets would behave during a similar panic in the future. Please note below exercise has no scientific basis, and besides no two events are exactly similar. A future crisis can be different in nature and scope, and the same results cannot be guaranteed.

A Bull-Market scenario:

IF

SPY gains 10%

IF

SPY gains 30%

IF

SPY gains 50%

Basket A (DGI)

Cap=400,000

3 - 4% Income

Gains 10%

=440,000

Gains 30%

=520,000

Gains 50%

=600,000

Basket B (Risk-Hedged)

Cap=300,000

6% Income

Gains 7%

=321,000

Gains 20%

=360,000

Gains 35%

=405,500

Basket C (High Yield)

Cap=200,000

8% Income

Gains 8%

=216,000

Gains 27%

=254,000

Gains 45%

=290,000

Bucket D (Cash, Gold, Treasuries)

Cap=100,000

2% Income

No Gain

=100,000

No Gain

=100,000

No Gain

=100,000

TIA=1,000,000

5% Income

(Average)

= 1,077,000

(+7.7%)

= 1,234,000

(+23.40%)

= 1,395,000

(+39.5%)

A Bear-market scenario:

SPY loses 10%

SPY loses 30%

SPY loses 50%

Basket A (DGI)

Cap=400,000

3-4% Income

Loses 6%

=376,000

Loses 20%

=320,000

Loses 32%

=272,000

Basket B (Risk-Hedged)

Cap=300,000

6% Income

Loses 4%

288,000

Loses 10%

270,000

Loses 15%

=255,000

Basket C (High Yield)

Cap=200,000

8% Income

Loses 15%

=170,000

Loses 35%

=130,000

Loses 56%

=88,000

Bucket D (Cash, Gold, Tres.)

Cap=100,000

2% Income

No Loss

=100,000

No Loss

=100,000

No Loss

=100,000

TIA=1,000,000

5% Income

(Average)

=934,000

(-6.6%)

=820,000

(-18.0%)

=715,000

(-28.5%)

In our opinion based on the past events, the strategy described in this article should capture the majority of the gains (certainly not all) in the rising markets (+40% vs. 50% or 23% vs. 30%). However, what's critical is that it would lose much less during corrections, especially severe bear markets (loses about 28% if the broader market loses 50%). In addition, more importantly, the portfolio should keep providing significant income, which would help ride out any bear market. In our example above, it would be providing an income of roughly $50,000 (about 5% of the investment capital), which will be good enough to ride out any storm. On top of that, the portfolio is maintaining over $100,000 of cash all the time to meet any emergency needs and provide a cushion in a bear market.

Total Income from the Four Baskets:

Investment

Income

Basket A

DGI Stocks (4% dividends)

400,000

16,000

Basket B

6% Income

300,000

18,000

Basket C

High-yield bucket (8% Income)

200,000

16,000

Basket D

Treasury, CDs, Cash (2% Income yield)

100,000

2,000

TOTAL

1,000,000

$52,000

Concluding Thoughts

The stock market has been jittery and volatile in the past month of the renewed fears of an escalation in trade disputes. The markets were too optimistic earlier of a quick resolution in US-China trade talks.

Nevertheless, there's always something that the markets are worried about and rightly so. But this is what makes the markets. We do not have the slightest idea whether the stock market indexes will be higher or lower by the year end or next year. The overriding factors are that the economy is still healthy and growing, unemployment is at its lowest, inflation is low, and there are no indications of any near-term recession. If the trade war escalates, the Feds is likely to cut the interest-rates a few times to offset the estimated 0.75%-1% loss of GDP growth.

We have presented above a diverse investing approach with multiple baskets which will provide an extra layer of diversification and safety with lower drawdowns. Above all, the combined portfolio should generate a very decent income of 5%, which should be of great help to ride out any storm. We do admit that this approach would require more work than a simple buy-and-hold index-investing and may not be appropriate for everyone. However, folks who cannot tolerate the wide swings in the market and can ill afford a 50% drawdown in a future event, this approach is highly suitable. Besides, the main idea is to get the readers thinking about a multi-basket investment approach.

Disclaimer: The information presented in this article is for informational purposes only and in no way should be construed as financial advice or recommendation to buy or sell any stock. The author is not a financial advisor. Please always do further research and do your own due diligence before making any investments. Every effort has been made to present the data/information accurately; however, the author does not claim 100% accuracy. The stock portfolios presented here are model portfolios for demonstration purposes; however, the author holds many of the same stocks in his personal portfolio.

Disclosure: I am/we are long ABT, ABBV, JNJ, PFE, NVS, NVO, CL, CLX, GIS, UL, NSRGY, PG, KHC, ADM, MO, PM, BUD, KO, PEP, D, DEA, DEO, ENB, MCD, BAC, UPS, WMT, WBA, CVS, LOW, AAPL, IBM, CSCO, MSFT, INTC, T, VZ, VOD, CVX, XOM, VLO, ABB, ITW, MMM, LMT, LYB, HCP, HTA, O, OHI, VTR, NNN, STAG, WPC, MAIN, NLY, ARCC, DNP, GOF, PCI, PDI, PFF, RFI, RNP, STK, UTF, EVT, FFC, HQH, KYN, NMZ, NBB, IIF, CHI, JPS, JPC, TLT. 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: Disclaimer: The information presented in this article is for informational purposes only and in no way should be construed as financial advice or recommendation to buy or sell any stock. The author is not a financial advisor. Please always do further research and do your own due diligence before making any investments. Every effort has been made to present the data/information accurately; however, the author does not claim 100% accuracy. The stock portfolios presented here are model portfolios for demonstration purposes.