A Bearishness Indicator Based on What Investor Is Doing

As discussed in [1], history shows us that more times than not the market will go against the majority. In other words, investor sentiment may be used as a contrarian indicator for the overall market.

There are different ways to measure market sentiment. For example, through

• Surveys of individual and professional investors
• AAII Sentiment Survey
• US Advisors' Sentiment Report
• S&P 500 Put Call Ratio
• CNN Money’s Fear & Greed Index

In this article, we will examine another bearishness indicator based on what investors are doing, not what their opinions are.

Cumulative Cash Flow Ratio

By measuring the ratio of

• Cumulative Cash Flow of "Bear + MM" and
• Cumulative Cash Flow of "Bull+Bear+Sector+MM"

we can calculate the bearish sentiment based on fund allocation (i.e., Bear / Total). The higher the ratio is, the more bearish sentiment is. Be noted that sentiment models don't work all the time and they are weak at pinpointing the exact date of a market bottom.

For comparing with S&P 500 (in solid black line), we have inverted the ratio (in dashed line) to be:

!CCFLALLEX:!CCFBEARM

in the chart (click the image to enlarge). We have also superimposed the "trend following indicator" Parbolic SAR on the ratio.

Interpretation of Parbolic SAR

SAR follows price and can be considered a trend following indicator. Once a downtrend reverses and starts up, SAR follows prices like a trailing stop. The stop continuously rises as long as the uptrend remains in place. In other words, SAR never decreases in an uptrend and continuously protects profits as prices advance. The indicator acts as a guard against the propensity to lower a stop-loss. Once price stops rising and reverses below SAR, a downtrend starts and SAR is above the price. SAR follows prices lower like a trailing stop. The stop continuously falls as long as the downtrend extends. Because SAR never rises in a downtrend, it continuously protects profits on short positions.

Conclusion

As discussed in [3], the primary trend of US stock market is down. However, currently we are in a counter-trend rally. From the high ratio of !CCFBEARM:!CCFLALLEX, the sentiment trend is becoming more and more bearish (i.e., moving lower in the chart above). Be vigilant, enjoy the rally while it lasts!

References

1. Investor Sentiment as a Contrarian Indicator by Wayne A. Thorp, CFA
2. Parabolic SAR
3. A Counter-Trend Rally? Knowing Your Risks

Housing: Furniture Business as Economic Indicator

Does the economy affect the furniture industry?  “The economy absolutely affects the industry, as furniture is a discretionary item” says Leslie Carothers of The Kaleidoscope Partnership, a social media and marketing company focusing on the furniture industry.^[1]

“When the economy is good people are definitely more willing to invest in furniture as well as better quality furniture as they have more money for such investments.” 

In this article, we will review current status of housing demand, economy in general and furniture business in specific.

Figure 1.  Housing market update (2021 Dec; Source: @SuburbanDrone) 

Housing Demand

Based on [18], the drivers for housing demand are ordered by their importances as follows:

1. Job Growth
• Based on [19], looking at employment in the construction industry can be a leading indicator for real estate
2. Consumer Confidence
3. Interest Rates

In year 2015, 43% of young men were living at home, which is the highest rate since 1940.^[2,4] The large number of young men living at home can be largely attributed to economic factors. Young people will start moving out as they became more economically independent.  As new household formation is improving, so will be housing market.

On 01/27/2016, the Conference Board reported that there are signs showing the changes are coming:^[5]

• New household formation is improving and closing in on its long-term average of 1.2 million units
• Household formation driven by older households, but continued improvement among younger households expected

Furniture Business

As economy remains strong, it will drive up housing demand (same for the market) and vice versa.  One way to view the health of current housing market is monitoring the furniture business.

In Sept, 2015, Fed reported that:^[6]

• While U.S. housing and auto sales showed strength over the summer, manufacturers were feeling pressure from China's economic slowdown and the oil industry was squeezed by lower energy prices

Two main contributors to the US growth are housing and autos in the current economy.  So, it becomes even more important to monitor the health of housing market.   One way to monitor the health of housing market is to watch the health of furniture business.

Based on the yearly forecast from BIFMA (Business and Institutional Furniture Manufacturer's Association), it remains optimistic for year 2016:^[8]

CURRENT U.S. OFFICE FURNITURE MARKET FORECAST
Year	Production	% Change	Consumption	% Change
2015 2016	$10.3 billion $10.6 billion	+4.9 % +4.2 %	$ 13.0 billion $ 13.9 billion	+6.5 % +7.1 %

However, housing trend can change anytime based on future economic conditions.  To monitor the strength of housing market, you can monitor the performance of the following furniture-related stocks:^[7]

• HNI
• MLKN
• SCS

As the Conference Board has indicated, new household formation is improving.  More household formation usually coincides with increases in consumer spending on not just housing, but also on adjacent products and services including furniture, electronics, kitchen products, and groceries, to name just a few.  Therefore, hopefully, we expect to see the improvement of furniture business in year 2016.

Photo Credit

• condoinnorthvancouver.com

References

1. Does the economy affect the furniture industry?
2. Millennials Are Setting New Records—for Living With Their Parents
3. Why Millennials Still Live With Their Parents
4. Young adults living in the parental home: 1960 to present 
5. New Report Finds a Major Shift Underway in Housing Demand
6. Fed report shows autos and housing fueling US growth
7. HNI: Why It Makes Sense To Buy This Furniture Maker (09/23/2013)
8. BIFMA (Business and Institutional Furniture Manufacturer's Association
9. First Autos Wobbled, Now It's Housing
• As I have often said, housing is the single most leading sector of the economy, and if I could have only one data series, it would be housing permits (which are less volatile than, and slightly lead, starts).
10. S&P/CASE-SHILLER 20-CITY COMPOSITE HOME PRICE INDEX
11. NAHB Housing Index
• NAHB survey has been a very valuable leading and corroborative macro economic indicator for literally decades now.
12. National Association of Realtors 
• NAR's Pending Home Sales Index for March will be released April 27, and Existing-Home Sales for April will be released May 20 (04/20/2016)
13. Canary In The U.S. Housing Market: Canadian Snowbirds Cash Out (good)
14. Housing Vacancies and Homeownership (St Louis Fed Res)
15. Housing: Limited housing supply is the reason for everything
16. MSCI US REIT Index
• Is a leading indicator for the real estate sector
17. NAHB Housing Market Index: "Builders Confidence at 12 Year High"
• The HMI correlates fairly closely with broad measures of consumer confidence
18. U.S. Housing: Going From Good To Great
• The most important driver for housing demand is job growth
• Consumer confidence is the next most important driver of home sales, after employment
• Contrary to conventional beliefs, empirical evidence suggests interest rates rank behind consumer confidence in terms of importance for the industry
19. What The Jobs Report And The Federal Reserve Told Us About Real Estate
20. RH Plunges After Big Miss On Soaring Mortgage Rates, Warns Housing Market Remains "Frozen"

BFCIUS:IND — Bloomberg United States Financial Conditions Index

The Bloomberg U.S. Financial Conditions Index is considered an accurate gauge of the overall conditions in U.S. financial and credit markets. It combines yield spreads and indices from U.S. Money Markets, Equity Markets, and Bond Markets into a normalized index. The values of this index are Z-scores, which represent the number of standard deviations that current financial conditions lie above or below the average of the January 1994-June 2008 period.

BFCIUS (3 Year Chart)

The highest level for the BFICUS index in the last three years was recorded around 07/04/2013.  On that date, it showed a positive sign that financial markets were on very solid ground.  After that date, however, BFCIUS index has gradually declined to a recent trough seen on 01/20/2016.

SPY (3 Year Chart)

Even the overall conditions in U.S. financial and credit markets has gradually descent to a recent trough in Jan., 2016, the US stock market overall still performed relatively well.  Does this bull market have more legs?  Only time can tell.

References

1. BFCIUS:IND (Bloomberg)
2. Stockchart.com
3. Bloomberg financial conditions index closes at record high
4. Chicago Fed National Financial Conditions Index (NFCI)
• A composite index based on 100 different financial indicators, and has proven to be a highly accurate leading indicator of financial stress at horizons of up to one year. 
5. Three Fed Indexes Are Pointing to the Tightest U.S. Financial Conditions Since 201
6. Cleveland Financial Stress Index
7. A hedge fund manager shares the 10 things that could surprise the market this year (good)
8. St. Louis Fed Financial Stress Index

Gardening: Protect Succulent Plants from Harsh Winter Temperatures

As temperatures dip during the winter, many gardeners find themselves in the time-honored tradition of hauling prized container plants indoors and out in order to protect them from freezes and harsh weather.

Succulent plants in containers especially need protection from the winter cold.

Succulents

In the world of gardening, succulents (jade plants or gasteraloes, for instance), have the ability to retain water in fleshy portions of their leaves as an adaptation to arid or dry climates. Succulent gardens require little maintenance and are excellent choices for beginning gardeners or those looking to create a drought-tolerant landscape.

However, the same adaptations that grant these plants such exceptional drought tolerance also make them more vulnerable to cold or freezing temperatures. Succulents can benefit from being brought indoors for the entire winter season. This benefit is mutual: while receiving protection from harsh temperatures, succulents provide refreshing color that can brighten any living space.

How to Upkeep

Succulents are prized for their low-maintenance upkeep, but to ensure that your plants thrive indoors in the winter, follow a few guidelines to keep them healthy.

• Use proper soil
• For succulent health, the selection of proper potting soil is very important. 
• As these plants are adapted to environments with very little moisture, well drained soil is essential to prevent disease or rotting plant roots. 
• “Cactus” potting mixes are available at most home and garden stores, and you can also make your own mix using online recipes.
• Light the way
• For healthy succulent plants, adequate light is far more important than water. 
• Plants that aren’t receiving enough light tend to exhibit “stretching” growth patterns, which is typified by a large amount of space between leaves. 
• South-facing windows with bright filtered light are generally ideal locations for over-wintering plants.
• Don’t overwater
• Over-watering is the most common reason for disease or death of succulent plants. 
• Seasoned gardeners often suggest skipping a regular schedule for watering established succulent plants. Instead, allow the soil to dry out between watering. 
• To check to see whether your plant is "thirsty," gently press the leaves between two fingers. If the leaves feel firm, hold off on watering for a while longer. 
• Once the leaves feel soft or slightly “squishy,” it’s time to water. 
• To prevent damaging the natural protective waxy layer on succulent foliage, avoid touching or splashing the leaves while watering.

For in-ground plants or containers too heavy to bring indoors, hardier species can survive, provided the soil is kept as dry as possible and there is adequate air circulation around the plant. You may observe some shrinking or “dying back,” but as temperatures warm, the plant will plump back up and resume active growth.

Article Source

• City of Frisco

Stock Investment: Risk-On vs Risk-Off

Risk-on, risk-off (RoRo) investing describes a process where investors move to riskier potentially higher yielding investments and then back again to supposedly lower yielding investments which are perceived to have lower risk.

In this article, we will review some indicators which allow you to monitor current market's risk appetite.

Risk-on vs Risk-off

Rising of risk appetite, which would tend to be good for stocks.  To measure risk appetite, ratios can be invaluable tools for making investment decisions. In the following discussion, we rely heavily on ratio analysis:

• SPHB:SPLV (High Beta/Low Volatility ratio)
• Risk on if high beta outperforms low volatility stocks
• Low Beta S&P includes the more defensive sectors of the market, including consumer staples (NYSEARCA:XLP), health care (NYSEARCA:XLV) and utilities (NYSEARCA:XLU). Representative names include Procter & Gamble (NYSE:PG), Becton Dickinson (NYSE:BDX) and Southern Company (NYSE:SO).
• High Beta S&P includes companies from the more cyclical and economically sensitive sectors, including industrials (NYSEARCA:XLI), consumer discretionary (NYSEARCA:XLY) and technology (NYSEARCA:XLK). Representative names include Yahoo (NASDAQ:YHOO),  Delta Air Lines (NYSE:DAL), and Best Buy (NYSE:BBY). 
• XLI:SPY
• Risk on if the ratio spread between a very cyclical and less or even non-cyclical asset rises
• XLB:XLU
• Same as above
• $COMPQ:$INDU
• Risk on if Nasdaq outperforms Dow
• SPY:IEF (Stocks/Bonds ratio)
• Risk on if stocks outperform bonds
• When the demand for stocks is greater than the demand for bonds, the aggregate economic outlook of all market participants is “net bullish.” 
• Conversely, when the demand for conservative bonds is greater than the demand for growth-oriented stocks, the aggregate economic outlook of all market participants is “net bearish.”
• Also, historically, during risk-off periods, long duration Treasuries becomes inversely  correlated to equities
• SLV:GLD
• Strength in silver relative to gold tends to occur during economic expansions and periods when the ‘risk on trade’ is in favor.
• However, whenever the RSI on the silver/gold ratio soars to 80 or higher it indicates excessive speculation.^[7]
• XLY:XLP (Consumer Discretionary/Consumer Staple Ratio)
• How to interpret?
• High ratio — risk-on
•  XLY (consumer discretionary section) is the most economically sensitive sector.
• XLF and XLK (Financials and Technology)
• How to interpret?
• Both are risk-on assets
• Rarely will they head in opposite directions.  If they do, use XLY and XLI for as tie breaker
• XLI (Industry) is economically sensitive sector because it supplies companies with capital-intensive goods and services needed for their operations.
• JNK:TLT
• Risk on if junk bonds outperform treasuries
• $TRAN:$UTIL 
• $DRG:$SOX (PPharmaceutical/Semis Ratio)
• How to interpret?
• High ratio — risk-off
• Defensive rotation: As healthcare gains on semiconductors.  It signals a change in sentiment and outlook (i.e., become risk aversion)
• VONG:VONV
• Risk-on if the Russell 1000 Growth Index has easily outperformed the value sector.
• Relative Performance of SPY, TLT, UUP, GLD, USO
• How to interpret?
• Risk-on if you see
• Strength in SPY and USO
• Weakness in TLT, UUP, GLD
• Stocks and commodities are riskier assets
• Dropping of US dollar (UUP) may be foreshadowing a return of risk appetite
• EEM
• If you are bullish on risk long-term, you should hope emerging market (EEM) stocks begin to reassert some leadership.
• FXA (Australian Dollar)
• Continued strength in the Australian dollar would be an encouraging sign for future economic growth and risk assets in general
• Rising of risk appetite would tend to be good for commodities and commodity-dependent currencies.
• VEU 
• Vanguard All-World Index Ex-U.S. ETF (VEU) is a good vehicle to monitor global risk tolerance and recession risks
• Insider Buying
• More buying means less risk

Conclusions

The traditional macro instruments such as commodities and currencies are difficult to value. But by far the biggest macro market - the bond market - is largely priced off central bank perceptions of what the economy is doing, and risk assets tend to be priced off those bond markets. Since mispriced assets can become even more mispriced depending on the macro climate and central banks' reading of it, timing is everything.  So, an understanding of the 'big picture' for you is far more important than valuation.

Finally, it is important to understand that volatility does not necessarily mean risk.  Volatility typically increases when equity prices are falling, however volatility levels can rise for a variety of reasons. Uncertainty about the outcome of an event like hitting the debt ceiling could push volatility levels higher without sending equity prices sharply lower.

References

1. The Fat Patch Weekly Summary 
2. How low oil prices went from blessing to curse
3. China's Year of Monkees
4. China Volatility Raises the Question: Did the Fed Make a Mistake?
5. What's behind slowdown?  (Deutsche Bank)
6. Is This A Bear Market?
7. Bob Hoye Interview
8. Risk “On/Off” indicator hitting 5-year support
• The decline has taken the ratio to 5-year rising support. The pattern looks just like global markets, which are testing 5-year rising support
• If the ratio does at support, it will have a large impact on portfolios come summer
• 90-Day trend is down, 5-year trend is up

A Counter-Trend Rally? Knowing Your Risks

Chris Ciovacco at CiovaccoCapital has shown the similarity of S&P 500 charts in year 2008 and 2016.^[1,2] Based on his findings, we may have entered a bear market and the two-day rally since Wed. (01/20/2016) could be a counter-trend rally unless proved otherwise—note that a counter-trend rally most often fails before retracing 62%.

Bull Market in 2009

Using multiple Moving Averages with different duration in different colors, Crhis has shown what S&P 500 chart looks like in 2009. When blue band is at the bottom, good things happen as shown below:

Bear Market in 2008

In contrast, when the blue band is on the top, bad things happen as shown in 2008.

S&P 500 Now

Looking at S&P chart on 01/22/2016, it also has the blue band went up to the top.

Counter-Trend Rally

Counter-trend moves are a normal part of all trends (including bear markets). Chris said that the current rise of SPY looks similar to the first counter-trend rally in a series of counter-trend rallies during the 2001-2002 period.  See Also the similar view Richard Shaw in [9].

Going a step further, Chris shows that the current counter-trend rally may gain from 2.02% to 7.97% depending on different targets it may reach in the short term.

In [7], Urban Carmel has provided similar price targets for this rally:

Using Fibonacci ratios, targets for a retrace of the recent fall are 193 (38%), 196 (50%) and 199 (68%). These levels correspond to gains from here of 1%, 3% and 4.5%, respectively. If SPY repeats the pattern from August, it will rise to $200, which was an important area of support during most of 2015. That would equate to an 8% gain from Wednesday's close. Is this a reasonable target? Yes.

Conclusions

CXO Advisory Group has been collecting data from market forecasters since 1998. The firm has tracked and graded thousands of market forecasts made by dozens of popular gurus over the years. CXO has concluded that the market experts accurately predicted market direction only 48% of the time. This says that Mr Market clearly has its own mind.

Even we cannot tell if the stock market has entered a bear market or not, investment in 2016 will remain a tough one for sure. To say the least, it will be very volatile.^[3,8]  Chris's model is based on facts and maintains maximum flexibility.^[1,2] As he said everything is probability. Based on current facts, we have an unfavorable risk profile in stock market. However, as in year 2003, 2009, and 2011, ugly markets can also begin to improve at any time.

Enjoy the current rally as long as it lasts. But, remain vigilant!

References

1. Monthly Stock Signals Similar To 2001 & 2008 (CiovaccoCapital)
2. Chris Ciovacco (twitter)
3. THE LAST INNINGS: HAS THE BULL MARKET ENDED? (Goldman Sachs)
4. Vanguard's Economic and Investment Outlook
5. Three Charts that Predicted the Current Downturn...and Have Yet to Recover
• Using three long-term charts, they all show us red flags that  foreshadow the longer term trend for stocks has either changed or is susceptible to further declines.
6. As Goes Oil, So Goes the Market
• Based on the confluence of oversold technical indications, Kurt Kallaus favors that an initial momentum low in stock prices has arrived and that a bottoming formation is the most likely outcome over the next 3 to 6 weeks.
7. The Fat Patch Weekly Summary 
• Any number of breadth and sentiment indicators strongly suggest that prices should rise further in the weeks ahead.
8. China Volatility Raises the Question: Did the Fed Make a Mistake?
• Miller’s data shows a dramatic slowdown in China that has both short- and long-term repercussions. He expects a lot more volatility in the markets, and this will affect the way the Fed views stability.
9. Where From Here For The S&P 500? (good)
• While the rally would take the price higher it would be short-lived, because it is a Contra Trend move. 
• The kinds of material changes in outside circumstances that could change the primary trend and take the rally to new heights might be something like Saudi Arabia reducing oil production or the Fed backing off of a March rate increase.
10. A hedge fund manager shares the 10 things that could surprise the market this year (good)
11. NYSE Margin Debt Renews Its Decline (Doug Short)
• Current level of NYSE margin debt is well off its record close in April and showing a pattern similar to what we saw following the market peaks in 2000 and 2008.
12. JPM Says Window To Buy Has Closed: "Start Fading The Bounce Within Days"
• Equity markets could be down this year irrespective of the US growth trajectory.
13. Short-Interest: Being Bear Is Back In Vogue
14. Citi Asked its Clients If We're Heading Into A Bear Market and This Is What They Said
• According to Citi, the wildcard in calling a stock market correction vs. a full-blown bear remains the direction of the Chinese economy.
• At the global level, recent events seem to reinforce the [Citi Chief Economist Willem] Buiter view that the risk of a China-led global recession is rising, but just how much of this is now priced into markets is unclear.
15. JPMorgan slashes outlook for stocks, citing Fed's 'diverging pressures'
• Having previously ended 2015 with an S&P price target of 2,200, JPMorgan recently cut that number to 2,000.Despite these risks, Lakos-Bujas did not call for a new crisis. 
• A recession "is a possibility, but I [Lakos-Bujas] wouldn't say that. I would more so say that [there's] concern over a bear market. With the S&P around 1,900 right now, that could mean we maybe see 1,700 at some point."
16. US consumer is the last defense against strong dollar drag on the economy
17. Scary Stock Charts Speak For Themselves (updated on 02/05/2016)
18. Timing The Bear Market And The 90/10 Rule
• If a nascent bear market has really appeared in the week ending June 26, 2015 as described in this article, try to avoid trading the bottom (i.e., to benefit from counter-trend rally) during the violent phase of bear market drop which is estimated to be in the following period:
• 02/2017 - 10/2017
19. Bear Market Rallies
• Bear market rallies can last as short as a week or as long as 3 months. Gains are at least 7-8% and can be as much as 20% or more.
20. Bill Hester, CFA ‏@billhester Feb 19
• Percent of up days in bull markets since the 1930's: 57%. In bear markets: 45%. Up day percentage since last May: 46%.
21. IDENTIFYING BEAR MARKET BOTTOMS AND NEW BULL MARKETS

Technical Analysis—Short Term / Long Term Volatility ($VIX / $VXV)

Looking at short term volatility ($VIX) vs longer term volatility ($VXV), it "may" help you spot the bottom of stock price. For example, when the ratio ($VXV:$VIX) gets above 1 it seems to indicate a bottoming process.^[1]

What is a bottoming pattern?

A double bottom pattern is a technical analysis charting pattern. It describes the drop of a stock or index, a rebound, another drop to the same or similar level as the original drop, and finally another rebound.  As its name implies, the pattern is made up of two consecutive troughs that are roughly equal, with a moderate peak in-between.

Although there can be variations, the classic Double Bottom Reversal usually marks an intermediate or long-term change in trend. Many potential Double Bottom Reversals can form during a downtrend, but until key resistance is broken, a reversal cannot be confirmed. For more details, read [7].

Figure 1.  Relationship of $SPX and VXV:$VIX ratio (02/05/2021; Courtesy of stockchart.com)

$VXV / $VIX Ratio

The $VIX is the more widely known index, representing the implied volatility (IV) of S&P 500 options that expire in 30 days. The $VXV is the exact same index, except it represents IV for S&P 500 options that expire in 3 months.  The $VXV is usually higher than the $VIX, but not always.

Using the weekly chart (click to enlarge) of $VXV:$VIX ratio (dashed line) superimposed with SPY price (black line), the ratio seems to bottom before the price most of the time (see Figure 1).  

 

Figure 2.  Relationship of $VIX / $VXV / $VVIX and $SPX (Courtesy of stockcharts.com)

 

$VVIX

 

Options-implied volatility of U.S. equity prices is measured by the volatility index, $VIX. Options-implied volatility of volatility is measured by the volatility-of-volatility index, $VVIX. Importantly, these two are conceptually and empirically different sources of risk.^[8]

Computed from $VIX options in an analogous way to the $VIX, the volatility-of-volatility index ($VVIX) directly measures the risk-neutral expectations of the volatility of volatility in the financial markets. In the data, we find that the $VVIX has separate dynamics from the $VIX, so that fluctuations in volatility of volatility are not directly tied to movements in market volatility (see Figure 2).

There are some common prominent moves in both series, such as the peak during…the financial crisis. Notably, however, the $VVIX also peaks during other times of economic uncertainty, such as the summer of 2007 (quant meltdown, beginning of the subprime crisis), May 2010 (Eurozone debt crisis, flash crash), August 2011 (U.S. debt ceiling crisis), and August 2015 (sell-off driven by the Chinese stock market crash). The movements in $VIX during these events are far smaller than the spikes in the $VVIX. The suggests that the $VVIX captures important uncertainty-related risks in the aggregate market, distinct from the VIX itself.

Warning

As always, invest with your own research and risk.  Please do your own due diligence.

References

1. Rare Event Signals A Short-Term Trading Opportunity: Buy Stocks
2. VIX & VXV - Spread Chart and Quote - TradingView
3. Weakest Indices create reversal patterns at 5-year support
4. The VIX/VXV Ratio: A Quick Way To Review Volatility Contango
• Contango, a bearish pricing pattern that indicates ample near-term supply.
5. The VIX and the Stock Market
6. Double Bottom Definition - Investopedia
7. Double Bottom Reversal
8. The importance of volatility of volatility 

Dividend Growth Portfolio—An Investment Strategy in a Volatile Stock Market

In Jim Puplava’s Big Picture: Forecast 2016,^[1] his prediction for year 2016 is that 2016 will be similar to 2015 except with much higher volatility.  To invest in a high volatility market, one strategy is investing in dividend-growth stocks.

In this article, we will touch upon the following topics:

• Advantages of dividends
• How to find trustworthy dividends
• How to spot risky dividends
• Investment ideas

Table 1. Dividend Growth Stocks Outrun the Competition Over Time
Source: Ned Davis Research

Advantages of Dividends

The advantages of dividends include^[3,25]

1. Provide a steady stream of income
• This income is steady and dependable
• Dividends on most stocks are paid every quarter. The income provides a return you can count on regardless of stock market conditions or price fluctuations.
2. Provide an inflation hedge
• These dividends can increase over time providing investors with a greater source of income and an inflation hedge.
• You don't get this with a bond. Bond values can erode with inflation, making the interest and principal worth less as a result of inflation
3. Have historically produced higher total returns than non-dividend paying stocks^[2]
• As shown in the book Mergent's Dividend Achievers, superior dividend paying stocks have not only outperformed the S&P 500, but they have also fluctuated less in down markets (see Table 1).
4. Have also been less volatile historically
• They tend to fluctuate less and hold up much better in down markets^[12]
• In declining markets, investors gravitate to more defensive issues such as dividend payers in search of refuge in a storm.
5. Provide investors with better corporate governance
• Studies have consistently shown that there is a direct link between good corporate governance and control with dividend payouts.
• Once a company implements a dividend paying policy, they seldom abandon it.
• Dividend payments have to be included in cash flow and budget projections each year.
• Dividends more closely line up with company earnings and cash flow.
• Management is reluctant to pay out dividends—or increase them for that matter—if the earnings aren't there.

How to find trustworthy dividends

Without saying, the companies you are investing in should:

• Have strong balance sheets
• While earnings can be subject to various adjustments, a positive free cash flow means a company has invested what it needs to maintain its business and has money left over to spend on dividends.
• Can handle a slowdown in the economy both domestic and abroad (if they do business overseas)
• Look at how much debt the company is carrying and whether it needs to tap capital markets to meet its commitments.

To spot good and reliable dividends, what should you look for? Here are the factors to consider:^[4,6]

• Management strategy
• They tend to have good management with solid corporate governance
• Management prioritized dividend growth as a key element of its shareholder value proposition
• They tend to have strong cash flow and earnings growth
• Historical record
• For example, McDonald’s has increased its dividend every year for the past 39 years.
• Sectors
• In studying the S&P 500 over the last 53 years, Siegal^[5] found 20 superior companies in three kinds of industries: consumer staples, pharmaceuticals, and energy.
• Even in market downturns, both utilities and consumer staples normally are holding up relatively well.^[23]
• Brand name and market share^[5]
• They are large and mature companies
• Once the business becomes mature and a brand name is established with a dependable customer base, they have less of a need for major capital expenditures, which consume earnings and cash.
• They have less of a need to come up with revolutionary new ideas or new products to stay profitable
• They are past their growth phase and tend to have lower R&D requirements
• They tend to be in businesses that provide a product that people continually consume.
• They tend to have a strong brand franchise that engenders repeat business and customer loyalty.
• This is also the reason they tend to enjoy higher profit margins on the things they sell.
• Valuation and stock trend
• Buy low. So, your decision should be based on analyst's target price (vs. current stock price)
• Higher dividend yield
• Choose stocks offering dividend yield which remains at a higher premium in relation to the 10-year Treasury rate
• To achieve the highest returns over a long time, you need to look for companies that consistently INCREASE their dividends.^[8]

How to Spot Risky Dividends

When pursuing higher yield, you should also avoid risky dividends. It’s best to be on the lookout for warning signs of a dividend cut early on, because by the time it’s finally announced, much of the damage to a stock has already been done. A cut in dividends could be imminent if you find:^[7]

• A spiking yield
• Ironically, an indication that a cut is imminent is a spiking yield
• What’s “high” in terms of yield (a stock’s annual dividend rate divided by its share price) depends on the industry;
• For instance, 4% for a utility stock is fine, but it invites skepticism in a faster-growing tech company or a more-economy-sensitive industrial company.
• If a stock that usually yields 4% all of a sudden yields 6%, and the cause of that burgeoning yield is a falling share price, it could be an indication that Wall Street doesn’t believe that the dividend is sustainable and that a reduction is in the offing.
• High payout ratio
• What’s “high” in terms of payout ratio (the amount of a company’s earnings paid out in dividends) depends on the industry.
• The average payout ratio for S&P 500 stocks is currently 37%.
• Tobacco stocks can pay out the majority of their earnings in dividends because a long-term decline in demand for their product means they’re not spending a lot on factories and equipment, yet the business remains profitable and generates tons of cash.
• But in general, anything above 70% to 75% should raise eyebrows—or at least initiate some research.
• Companies carrying too much debt—they will be forced to choose between protecting their credit rating and protecting their dividend--will cut the payout every time.

Investment Ideas

In an environment of rising interest rates and lower liquidity, Uncommon Wisdom Daily Team recommends choosing^[9]

• High quality over low quality
• Dividend growth over high dividend yield
• Liquidity over leverage
• Large caps over small caps
• Large-cap companies tend to do better in times of uncertainty, which we definitely are seeing now.
• Yield on Cost^[26]
• Keep track of the yield based on your cost basis

In [8], David has offered his Dividend Growth Portfolio for retirement in 2016. As usual, before you invest, do your own research. The investment ideas list here is just your reference—if you invest in any stocks discussed here, you take your own risks.

If you prefer to invest in ETF with the theme of dividend growth, there are some choices:^[10,24]

• NOBL (ProShares S&P 500 Dividend Aristocrats ETF)
• The only ETF that invests exclusively in large-cap S&P 500 companies with the best track records of year-over-year dividend growth (25 straight years as a minimum).
• Has 52 holdings, a current yield of 2.2% and a low expense ratio of 0.35%
• SDY (SPDR S&P Dividend Index NYSE)
• Tracks the S&P High-Yield Dividend Aristocrats index
• Uses a much wider net — 1,500 possible stocks vs. 500. So in the tradeoff, investors get more total holdings and a wider range of company sizes.
• Owns the highest-yielding S&P 1500 index constituents that have managed to increase their dividends for at least 20 straight years
• Has a 50/50 split between large caps and small/mid caps
• Has a total of 101 holdings, a dividend yield of 2.7%, and a low expense ratio of 0.35%.
• O’Shares ETFs^[24]
• OUSA (USA)
• OEUR (Europe Non-hedged),  OEUH (Europe Currency-hedged)
• OASI (Asia Non-hedged),  OAPH (Asia Currency-hedged)

References

1. Jim Puplava’s Big Picture: Forecast 2016 – Shelter in a Storm
2. O'Shea, Peter & Worrall, Jonathon, Beating the S&P with Dividends: How to Build a Portfolio on Dividend Paying Stocks, by Peter O'Shea & Jonathan Worrall, John Wiley & Sons, 2005, p.42.
3. The Investment Constant (FinancialSense)
4. 4 Safe Dividend Stocks to Buy as 2016 Starts With Market Rout
5. The Future for Investors: Why the Tried and the True Triumph Over the Bold and the New
6. Mergent's Dividend Achievers
7. 5 Stocks at Risk of Dividend Cuts in 2016
8. Dividend Growth Portfolio - 2015 Was A Good Year With Bad News At The End
9. Don’t Get Too Spooked by This Sell-off
10. What to buy as the market dips…
11. Ned Davis Research
12. The 80-year-old fad: Dividend investing comes back into vogue
13. Free cash flow
• If you own a Charles Schwab account:
• Log in to your account, click on "Research," and enter a ticker symbol
• To the right of the stock's "Summary" page, click on "Statements," then select "Cash Flow Statement"
14. Bear Market Risks Increasing At Rapid Rate (01/15/2016)
15. 9 Good Dividend Stocks to Buy During the Market Selloff
• ABBV, AMGN, BA, CMCSA, HD, JPM, MSFT, NLSN, WEC, 
16. Four Strategies for Navigating the Equity Environment Ahead (PIMCO)
• Dividends can be a more stable source of returns, but there’s a caveat: stocks that simply offer yield may struggle in a rising rate environment. 
• This reinforces the case for a global dividend portfolio (which can benefit from investing where rates are lowest or decreasing around the world) and a focus on companies growing free cash flow and management committed to dividend growth.
17. Seeking Alpha Market Currents Dividend News. [Online Database].
18. Wall Street Journal. Dividend Declarations. [Online Database].
19. Merrill Lynch’s Top Dividend Alpha US Stocks Picks for the Rest of 2016
• KHC, NEE, EPD, HES
20. A Counter-Trend Rally? Knowing Your Risks (Travel to Wellness)
21. Can Big Oil Continue to Pay Dividends?
22. Merrill Lynch Says No Value in Energy: Only 2 Dividends Safe Now
• With the exception of two companies, Merrill Lynch lowers the dividend outlook for all large cap U.S. oil
23. Jim Puplava’s Big Picture: The Risk to Dividends – Know What You’re Buying
24. ‘Shark Tank’ for Stocks
25. How to Navigate a Range-Bound Market (The WisdomTree Blog)
26. Dividend Stock Investors: Pay Attention to Your ‘Yield on Cost’
27. 3 Low Volatility Dividend Stocks To Make Staying The Course Easier
• JNJ, GIS, PEP
28. The 10 Most Recession-Proof Dividend Aristocrats
• 1. MCD 2. WMT 3. ABT 4. GWW 5. BDX 6. ED 7. KO 8. JNJ 9. ADP 10. CLX
29. Two Dividend Stocks We Favor (AAII)
• ETN, PG
30. Earnings and Cash Flows: A Primer on Free Cash Flow