It should be clear to almost everyone by now that prices have risen sharply over the past twelve months. At the same time, economies around the world are plummeting. Stagflation at its finest. Unsurprisingly, many stocks have fallen, too. As a result, most people have become poorer in real terms, whether they invest or not. It is time to answer the urgent question of how to successfully weather this painful bear market.

We didn’t have a classic bear market for more than a decade. The last one occured during the Great Recession (or Great Financial Crisis – GFC) of 2008–2009. The US indexes peaked already during 2007 and only found their lows during March 2009.

A bear market is typically characterized by stock prices (or indexes) falling by at least 20%. On average, such a bear market has a duration of between a year and a year and a half and is most often accompanied by a recession, i.e. a temporarily shrinking economy over at least two quarters.

The US indexes plateaued for the last time at year end 2021. Since then, the S&P 500 has lost roughly 20%. In June this year it already breached this mark, temporarily.

Most especially young “investors” have never experienced what it feels like losing money over a stretched period. Whereas “buy the dip” was a successful strategy during the last decade, now it is not anymore. Currently, we are in the ninth month of overall falling prices.

At least that is what media and overall sentiment want to tell us.

Quite the opposite can be observed when you look at your supermarket or energy bills, however. Here, prices have risen quite dramatically without any doubt.

The chances are high that in this scenario you have lost wealth in real terms, because your purchasing power vanished. Your investments suffered and your savings can buy roughly 10% less than a year ago. Or did you receive a salary raise by at least 10% to compensate for this?

But the good news is, you don’t have to be the bag holder. I myself managed my personal portfolio well through this bear market by staying away from the wrong stocks and investing in the needed ones. At least in most cases… 🙂

Who says that you have to stay on the sideline and passively watch your purchasing power decline? Maybe you could – in case you prepared yourself and your investments properly – be even one of the few beneficiaries of the current malaise? But you need to get active.

It is outright wrong to generalize that with falling indexes worldwide one’s personal portfolio has to follow suit. You can even capitalize on this situation!

You should take some time to first make sure you understand the current situation (I hope today’s Weekly comes in handy) and then turn some of the right screws in your investment portfolio.

Today, we are going through the basics you have to understand about the current environment. We will see that not all stocks have fallen. There are even many stocks that have risen or at least gone sideways since the beginning of the year!

But what is being portrayed (and thus felt) is that “the stocks” or “the stock market” – whatever that is – have fallen.

News sell better the scarier they are.

Let’s bring in clarity!

Why most stocks are NOT high-inflation-proof

The first thing to understand is very simple: With inflation, i.e. rising prices, your available money can buy less for the same amount. The higher the inflation rate, the higher this negative effect. Plain and simple.

For example, if inflation is 2% p.a., then you purchasing power will halve after 36 years. But if inflation is 6%, then you will be able to buy only half so much already after 12 years. What if inflation is around 8–9% like currently? Yes, in 8–9 years you will need double the money in nominal terms to maintain the same purchasing power.

It makes sense that one should protect the purchasing power by investing. When something falls (purchasing power of money) something else has to rise. Most people do not understand this up until here. You better should.

You always have money on one side and assets (stocks, real estate, resources, everything that money can buy) on the other side.

Maybe stocks that generate over the long-term an annual performance of around 9–10% per year (see here or here) could be a great idea?

We start with a stubborn myth that is outright wrong and misleading. How often did I hear during 2020 and especially 2021 that stocks are the place to be in an inflationary environment? Sure, compared to bonds, savings accounts, life insurances or even in many places property, stocks should outperform.

There is a big but… In many cases it is dangerous to generalize certain things.

How can it be said that “stocks” in general perform well during high inflation? There are certain companies that profit from rising prices, because they sell the products that become more expensive while their costs stay either the same or only rise slowly. This is the minority! The truth is, most companies suffer when prices rise too fast.

Higher prices at too fast a pace are the reason why the majority of companies are suffering economically during times like the current.

Revenues may rise nominally due to rising prices for consumers.

• But first, often below inflation (at least not above it to achieve real growth). Real growth in the current environment needs growth of at least 10%. Otherwise, it is only a nominal growth, but not in real terms (loss of purchasing power!).
• and second, the cost side of many companies explodes. Margins erode and inventories built up due to less demand for certain nice-to-have things. Profits and especially cash flows turn south.

Just look what happened to Walmart (ISIN: US9311421039, Ticker: WMT) or Target (ISIN: US87612E1064, Ticker: TGT), the two big US-retailers. They built up inventories too fast and could not sell their stuff anymore to the consumers, either completely or only at massive discounts (here or here).

One week ago, there were even news, that many retailers cancelled billions worth of US-Dollars in orders for the coming holiday season (see here). The holiday season is the busiest period of the year where many retailers generate the bulk of their revenues! Are they doing this because the economy is doing so well?

Target, which has more discretionary products, managed to shrink operating profit just in six months by a third. Inventories ballooned to around 15% of revenues – that is nearly double of what they usually have had over the last ten years on their balance sheet. Free cash flow even has gone negative due to more capital tied in inventories.

In the first graphic below, you see operating income, inventory and free cash flow of Target over the last ten years on an annual basis (i.e. the massive drop over the last six months is not built in). You see how inventory started to grow massively:

And here you see on a semi-annual basis the same metrics over the last three years. You see the drop in operating profit and free cash flow in the last column. These are the most recent numbers from the company. Free cash flow even went negative, as described above:

Please don’t forget, during high inflation, most people have less money to spend. They focus on the necessities. This is felt by many companies.

How can stocks of such companies rise under these circumstances and be “inflation-proof”? Don’t throw common-sense away!

When profits and cash flows dry up, so do the values of the underlying companies. Stock prices in the long rund always follow the economic reality of the underlying businesses.

This is what many companies have to cope with.

Due to low economical performance and also often unfavorable outlooks, stocks go down. When valuations are high, then the effect is more pronounced. Just look at what happened to tech stocks that were valued like crazy and now have even more dire outlooks than they already had during times of perverse optimism (optimism is not the same as reality and common-sense!).

How can “stocks” in general profit in such a scenario?

You see why on average there is a good reason to say that stocks suffer. Some are affected more than others while only a few specific are profiteering.

The correct thing to say would be: Most companies and thus their stocks suffer, but one has to pick those that either suffer the least or even are able to capitalize on this situation!

With this in mind, you should understand why I very mich dislike such terms like “the stock market” – it is too inhomogeneous to be generalized! And it is why I don’t like blind investments into ETFs with the belief that everything will be alright (see my article about the hidden dangers of ETF investing here).

Let’s take a look at the S&P 500 as a proxy for the broader US economy.

Over the last twelve months, out of 504 stocks (yes, indeed 504, see here and sort by 1yr performance; all data as of the closing of 21 September 2022):

• there are 147 stocks (29%) that have gone at least sideways (or not lost)
• 92 stocks (18%) have a performance of at least +10%
• 56 stocks (11%) have a performance of at least +20%
• 37 stocks (7%) have a performance of at least +30%
• 19 stocks (3.8%) have a performance of at least +50%
• 4 stocks (0.8%) have even doubled

Seeing the numbers above, it is hard to believe that one could have lost money over the last twelve months. Especially, when you consider that the returns are stock performance only, i.e. without including dividend payments!

What pulled down the index are two things:

• more stocks lost than gained
• among the losers were many heavyweiths like
  – Meta (former Facebook; ISIN: US30303M1027, Ticker: META)
  – Netflix (ISIN: US64110L1061, Ticker: NFLX)
  – Adobe (ISIN: US00724F1012, Ticker: ADBE)
  – PayPal (ISIN: US70450Y1038, Ticker: PYPL)
  – or Intel (ISIN: US4581401001, Ticker: INTC)

For a better overview, here is a screenshot from FinViz with a current heat map of the S&P 500 constituents and their performance over the last twelve months:

More red than green and many big bright read fields while rather smaller green ones (except Apple).

Since the beginning of the year, i.e. from when the bear market began, there is even more red:

You see, many big red fields and only a few smaller ones in grey or green.

Nearly all the heavyweights went into correction mode.

But there are also companies that haven’t lost either anything or only slightly since the beginning of the year, namely:

• many companies from the health care and health care plans sector (in the middle under communications): these are defensive companies with often reliable dividend payments and more or less independent from the overall economy
• in consumer defensive in the top right corner there are red and grey fields; overall these are also rather defensive and reliable dividend-paying companies like Coca-Cola (ISIN: US1912161007, Ticker: KO), Philip Morris (ISIN: US7181721090, Ticker: PM) or Pepsi (ISIN: US7134481081, Ticker: PEP)
• at the bottom to the right, before the corner, you have utilities – also defensive businesses with often long histories of dividends
• and of course to the right with the most green fields, we have the energy sector, that has one of its best years since long – these are definitely not defensive companies, but purely cyclical. However, they are also often reliable dividend payers

As a result, you see, it could have paid off to switch from aggressive to defensive. Among the companies in grey or even green, there are very often established businesses with everyday essentials, strong cash flows and reliable dividend payments.

On the other side, many non-dividend-paying companies and unprofitable ones, have lost the most. The same with highly valued growth stocks, even if profitable.

In the next section, we will dive somewhat deeper into the topic of dividends during bear markets. We will have a look at the 1970’s where we for the last time had a high-inflationary environment.

The power of reliable dividends in bear markets

A company’s dividend policy can be a testament to the management’s confidence in future earnings, cash flows and overall stability of the company.

This is of course only true, if the business is stable and business economics allow for distributions without sacrificing the long-term well-being of the company.

In simple terms, the business must first earn what it intends to pay out at a later time.

Here is where cash flow comes into play. Only real cash flow can pay dividends, not (accounting) earnings.

As we have seen in the last section, there were especially many dividend paying businesses from defensive (or profiteering) sectors. What they all have in common is that they generate very healthy cash flows.

Even in the current environment, because their goods and services are still needed.

It was not only a good idea at the beginning of the year to invest into such companies. I think it is still appropriate to play defense, because valuations of most stocks are still very high and the economic environment is further turning south.

Inflation is still crippling the incomes of many households, hence it would be pure gamble to hope for a turnaround.

Let the gamblers play.

As long as risk/reward is unfavorable, there is no need to hurry.

What you should focus on instead is a portfolio that is weighted to dividend paying and thus income generating assets for you.

To proove that this is a good idea, let’s have a brief look at history. The 1970’s were the last period of really high inflation. Officially, the inflation rates were much higher than today (in the double digits). But it is also true, that the measurement of inflation has been changed several times (see here or here)

the last link is behind a paywall, but you can circumvent it with a Mac by reloading the page and quickly press cmd + shift + r for “reader mode” as long as the page reloads.

Better trust you gut feeling and your bills, not government statistics!

A recent study titled “The Power of Dividends: Past, Present and Future” form Hartford Funds (see here) has very interesting stuff for us.

If you have some spare time than it would be very well invested to read those 11–12 pages. The study is for free!

For warm-up, I want to start with a quote from the study:

In the 1990 film “Crazy People,” an advertising executive decides to create a series of truthful ads. One of the funniest ads says, “Volvo—they’re boxy but they’re good.”

Dividend-paying stocks are like the Volvos of the investing world. They’re not fancy at first glance, but they have a lot going for them when you look deeper under the hood. In this insight, we’ll take a historical look at dividends and examine the future for dividend investors.

https://www.hartfordfunds.com/dam/en/docs/pub/whitepapers/WP106.pdf

This is how you should think of dividend stocks.

They are most often not spectacular and you will most likely not make big gains in the short term. But that is not the goal. You want to have them in your portfolio for stability and reliability. As a big plus, because of their established business models, they are capable of earning strong cash flows and reward their shareholders with dividends, that in most cases rise over time.

Dividends are real cash that is flowing back to its investors. This way, your war chest builds up and you can reinvest your means at any time to buy more stocks. Over time, these reinvested dividends produce more dividends (and ideally stock performance) for you.

This is the power of compounding. We already touched on it briefly in my article “Buy Now Pay Later Or Financial Independence Retire Early” (see here).

The Hartford Funds study takes a long-term view on the significance of dividends from 1960–2021. I total, 61 years is a good fundament to build on.

The authors conclude and show that an astonishing 84% (!) of total investment returns are attributable to dividends, using the S&P 500 as a broad market index as an example.

Concretely, they show that, if you (or your grandparents) invested a lump sum of 10,000 USD in 1960, without dividends reinvested, you would have “only” a performance of 79.5x. “Only” is of course meant ironically, but you will understand, when I tell you that including reinvested dividends, over the same time frame, the total performance would have been 495x!

See for yourself:

You could say, okay, wow. But what implications does it have for the current environment for me?

I have good news for you.

The authors calculated statistics decade by decade, where we can draw more useful information out.

Here is a second figure that explains it all (I will conclude everything necessary after the graphic):

Not every decade is the same. Dividend contribution varies in every time frame.

Important for us are the following conclusions:

• during bull markets like most of the 1950’s, 1980’s, 1990’s or 2010’s, the impact of dividends was rather low, especially during the 1990’s and 2010’s were technology stocks went through the roof.
• exactly the opposite during the period of high inflation and low returns from stock performance in the 1940’s and 1970’s: Around 67%, respectively 73% – or the vast majority – of the investment performance was due to dividends!
• in the 2000’s where we started with the burst of the Dotcom bubble and ended with the GFC (the so called “lost decade”), you would have earned only what you received in dividends

This is of course a simplified model that has certain assumptions and flaws. Assumptions are based on a fictive investment in the S&P 500.

But the results are crystal-clear:

• during bull markets dividends lose in total contribution
• the other way around during declines of stocks and high inflation: the most robust companies with dividends should be the preferred ones!

When you invest in a company that has stable fundamentals, solid earnings and secure dividends, you will automatically be calmer and more relaxed during market turbulences. Not only is this a financial advantage, but also a psychological one, that should not be underestimated!

This is not all of the good news, yet. I have a last point for you to round up my (and the author’s) arguments in favor of dividend paying stocks.

Although they pay dividends that get subtracted from the stock price (because real money leaves the company), these type of stocks even lose less during bear markets!

This makes sense, as they are the shelter in the storm for many investors, who understand this subject.

On p. 6 of their study, the authors write:

Companies that grew or initiated a dividend have experienced the highest returns relative to other stocks since 1973— with significantly less volatility.

https://www.hartfordfunds.com/dam/en/docs/pub/whitepapers/WP106.pdf

And here is the table with the results:

If you prefer it more visually, here is your graphic that shows the total returns:

Not only do dividend growers & initiators throw off the highest total returns, they also have the lowest beta (correlation to the benchmark) and the lowest standard deviation (lowest volatility).

This is why dividend stocks are so important.

During a bear market like the current one you can lay the seeds for the next upswing. Some day, it will come, inevitably. Until then, collect your dividends, stay defensive and rest assured.

And take care of not being wiped out! The better you sail through the storm, the more substance you will have for the following bull market!

Demand side vs. supply side – again

We not only have falling stock prices, but also sharply rising everyday prices. At the same time, the economy is turning south.

This phenomenon is called “stagflation” by economists. It is a word composed of “stagnation” and “inflation”.

Usually, the cure for high prices should be – high or higher prices (see here)!

Why?

Because prices consist of supply and demand, one influences the other. The (academic) theory says that with higher prices affordability and thus demand should shrink.

That make sense at first sight.

In many areas like the sector of basic materials this seems to be true. Prices for steel, copper or aluminium have fallen massively from their highs of last year.

I admit that the following is not the nicest graphic optically, but it shows you the direction of the aforementioned metals prices:

The reasoning goes the following: Due to weaker demand as a consequence of slowing economic activity, prices are falling.

So far, we have only mentioned the demand side.

But this is idiot-like and very naïve logic due to oversimplification.

And this is the problem I have. Not only with the taught theories but with academics in general and economists specifically.

I can’t help but shake my head when I read things like economists are surprised by certain results (the average Joe is not, by the way), such as last week’s U.S. inflation numbers, where they play guessing games about who will hit the decimal place of the inflation rate most accurately.

My mantra is, better be roughly right than precisely wrong. See the big picture trend and act accordingly – they see and prefer the other way around and micromanage stuff that is falsely understood…

I myself am also an academic with three degrees, but I am someone who observes his environment and draws conclusions from what he sees. Also, I am ready to admit when I did a mistake. My goal is to learn from my mistakes and to do better next time.

What you should learn at university is learning how to learn. Be curious and take your lessons learned from the mistakes you did. Most of the theoretic content taught is garbage, especially in the humanities courses like economics. Economics is even neither a traditional course at universities nor a classic field of research, as the first noble price for economics was only given in 1969 (see here).

Not so the economists, that still rely on their outdated theories that demand is the parameter that has to be influenced artificially to get certain outcomes they want.

Since when has central planning worked and achieved the desired outcomes?

Give more of the medicine that does not work to heel the symptoms of the patient instead of tackling the root causes…

You heard it already from me, and you will be hearing it often. It is the supply side that is the way more important factor.

At least in the case of steel and aluminium, we are dealing with over-supplies, not too little demand. Just look into the reports of the businesses. In both cases China is the biggest producer that is running on over-capacities. I cannot say the same about copper, which is said to become scarce during the current decade. Let’s wait and see.

But, as you might remember in my Weekly about the hidden risks of ETF investing (see here), I argued massively in favor of focussing on the supply side than on the demand side.

Here is the critical passage once again:

But demand is way harder to forecast than supply. You have way more variables / customers that determine demand. Plus, while demand can come back (or fall down) relatively quickly and cannot be predicted sufficiently over a longer term, supply can!

Due to all the regulations, political interventions, regulatory uncertainties, permitting processes, ESG and financing hurdles and of course plain time it takes to dig holes before you pull out resources from the ground, supply is way more slow-moving.

https://financial-engineering.net/hidden-risks-of-etf-investing-how-to-invest-instead/

Hence, we have to look at where supply is tight.

This leads us to the unloved anti-ESG sectors of oil, gas and coal.

Why higher inflation and stagflation is here to stay – is it too late to invest in commodity stocks?

It depends on where you look. All commodities of course have a component of cyclicality to them.

Thus, my answer would be a clear “Jein” in German (mixture of yes and no; “ja” and “nein”).

I like to differentiate between energy and basic materials, as there are those two sectors in the heat map.

And this is where my interest for the “dirty” stocks arose from.

They unite on themselves many points that make a common-sense investor’s mouth water:

• low valuations (still, even after the run up)
• low sector weighting (see my Weekly about the hidden risks of ETF investing (see here), where I wrote about an imminent sector rotation)
• strong cash flows
• producing everyday essentials
• proven business models
• no way of doing without them (sorry ideologists!) for at least the next decades
• interesting supply situation – cautiously said

Let’s put gas and coal on the back-burner for now and focus on oil.

The argument of the last weeks and months was that the unavoidable recession (that is no recession anymore, see here) will push down demand and thus reduce oil prices.

I have already expressed myself about this arguing in the last section.

Hence, how does the supply situation of the oil sector look like?

I don’t want this part to be too long, it could be a separate Weekly on its own. What you must know are two things: What is oil needed for and how much oil supply is to be expected?

The first question, what is oil used for?

Specifically, I find this graphic very interesting and the page of Visual Capitalist in general. Lots of good stuff they have.

You see in this graphic two main things:

• around 70–75% (the EIA – U.S. Energy Information Agency – says around 67% here), of oil is used for transportation purposes.
• around 10% is used for “other” things. But the other things include important products like packaging material, tires, light bulbs and many other essential everyday items.

Oil is needed nearly everywhere. It is even needed to produce the so-called renewable energy producing machinery.

No way to circumvent this, at least not in the near- and middle-term.

The second question, about the expected supply.

The graphic above only shows target production quotas, not real supply deficits. But it is important to take home that the oil producing powers are lagging in increasing production.

This was a graphic reaching until May 2022. The latest news as of Monday, 19 September 2022, is that the production hole gets even bigger with an expected deficit of 3.6 million barrels behind their plans (or already a third more) per day (see here).

I think, the oil producing and selling countries do not feel uncomfortable with this situation and higher oil prices per se…

A plea for the demand side advocates: Have a look at the next figure from official administrative desks of the EIA (US Energy Information Administration) – in order to avoid taking not unbiased charts from the oil industry itself:

Even his agency says that oil (as well as gas and coal) consumption overall is going to rise – though slowly having less market share with time. And oil will stay the biggest source!

It is wasted time to speculate about what will be in 30 years, when we often even do not know what will happen tomorrow.

But we can anticipate what is going to happen likely in the oil sector as a whole.

Mix into these hard figures topics like politicians that destroy the supply side with ideological theories they are pursuing. Investments in the oil industry have fallen over the last decade.

In the past, it was common for the oil companies to save money during downturns and invest during upturns (build new capacity).

Today, they are not investing more, but instead maximizing free cash flow and rewarding shareholders.

This is the graphic I showed two weeks ago (see here):

And it only went until 2020…

We have high odds in our favor that oil will continue to rise, soon.

As a big plus, overall oil sentiment turned massively bearish again. Oil has been falling for three months in a row now and dipped from nearly 130 USD per barrel (Brent oil) temporarily under 90 USD per barrel. Expectations go to falling demand and thus further falling prices.

You know what I am thinking about this. Better let your common sense guide you. When everyone sits on the same side of the boat, it could fall over…

I am bullish for oil. Historically, after periods with falling prices (the last such one was from 2014–2020), there always come bull markets with rising prices.

They also last for years, as supply cannot be increased overnight!

In this connection, I am proud to announce the start of my Premium Membership and my first research report.

I have researched a company from the oil sector with an interesting capital allocation strategy that fits perfectly into a well thought-through portfolio of stocks and differs from how the oil supermajors (the biggest oil firms) are handling shareholder’s money. It is not even unlikely that with time its dividend yield will be in double digits.

I explain all you need to know in my exclusive research report for my Premium Members, due Saturday, 24 September 2022!

As a special Thank You! for my supporters from the first hour, I am going to send to everyone who signs up for my free weekly newsletter until Saturday, 24 September 2022, 10:00 a.m. CEST (German time), this first research report for free, shortly after the deadline. After this deadline falls, it will only be accessible via a paid Premium Membership.

Note: This service will not be accessible for every country due to different VAT, GST and Sales Tax regimes. I am starting with some selected countries and plan to increase my offerings with time. Should you not be among those selected countries, please drop me a line. If interest gets high enough, I am ready to open up more countries.

Conclusion

Today, I explained to you what the current situation is like in basic terms.

You should understand that it is mandatory to preserve purchasing power. When you do not invest, you lose through inflation. When you invest wrongly, you suffer losses from your bad stock selection.

Only the right stocks will stabilize your portfolio and enable you to sail through the current storm. I showed you, why dividend paying stocks should be among them.

Especially, energy stocks are worth a look or two.

I am starting my Premium Membership with an interesting energy stock that checks the boxes I described in today’s Weekly.