How to Beat the Coming Bear Market

I don't know when we'll see the next bear market. But like you, I know it's coming. And it's not a matter of "if," but "when." Today, I'll tell you how you can prepare your portfolio to not only survive the bear, but also emerge better off than if it had never happened at all.

Siegel says
I had the pleasure of hearing one of the world's great investing minds deliver the keynote speech at a Fool investing seminar. Wharton professor Jeremy Siegel is best known for his book Stocks for the Long Run, and his latest, The Future for Investors, is another classic. In this book, Siegel lays out the secret for successful investing through all market cycles, and it's in complete agreement with what James Early teaches in the Motley Fool Income Investor newsletter.

It all boils down to the incredible importance of owning dividend-paying stocks -- and reinvesting those dividends. It's a concept I wrote about in "The Greatest Investing 'Secret.'" Today, I want to expand on this by showing how bear markets can actually help your returns.

• Dividend-paying stocks act, in Siegel's words, as "bear-market protectors" and "return accelerators" during down markets.
• Dividend yield is a huge factor when it comes to actual returns. The yield is simply the dividend per share, divided by the price. So a $100 stock that pays $2 in yearly dividends has a yield of 2%. When stock prices fall, yields obviously increase, as long as companies don't cut their dividends more quickly than the prices drop.
• When those dividends are reinvested, they purchase more and more shares at lower prices during a bear market. These extra shares act as another bear-market protector.
• Then, when share prices reverse, the extra shares act as a return accelerator, rocketing total returns higher.

Beating the Depression
The greatest example of this process involves the stock market crash of 1929 and the Great Depression that followed. On Sept. 3, 1929, the Dow Jones Industrial Average hit 381 -- a level it wouldn't reach again until November 1954. That incredible rough patch pained investors for a full 25 years.

But Siegel related a surprising truth: The average stockholder who reinvested dividends actually showed a positive return of more than 6% per year during that 25-year period, easily beating the performance of bonds and short-term treasuries. Think about that the next time you hear someone say it took 25 years for stock investors to break even during that period. That's true only for those who didn't reinvest their dividends!

Siegel has two more surprising revelations:

1. If the Great Depression had never occurred, and if dividends had made a smooth ascent while stock prices remained stable, things would have been far worse for long-term stock investors. Investing $1,000 at the beginning of this fictional stable period would have produced only $2,720 by November 1954. That's 60% less than what dividend reinvestors actually accumulated in real life.
2. A dividend-paying stock that falls will recover its total value even if the price never recovers, thanks to the extra shares purchased (bear market protector). In fact, the greater the fall, the fewer the number of years it takes to reach break-even status. And, of course, if the price recovers, the gains are magnified because of the extra shares (return accelerator).

Thus, you can see that periodic bear markets are actually very beneficial to long-term dividend reinvestors. Siegel illustrated this with a case study of Philip Morris (now Altria Group). Because of bad publicity and lawsuits, the cigarette maker's price was the same in March 2003 as it had been 12 years before. Yet those who reinvested their dividends earned an average of 7.1% per year throughout that period. Then, when the stock price recovered, reinvestors had twice the number of shares than they had 12 years before.

Good for bulls, too
Finally, to convince you that owning strong dividend-paying companies is a no-brainer, these stocks perform well across all market cycles. Consider that the 20 best-performing survivor stocks from the original S&P 500 in 1957 are all dividend payers. But even beyond those 20, most of the top-performing original S&Pers are dividend payers. Here's a small sampling of these "corporate El Dorados," as Siegel calls them, and their returns during his 1957 to 2003 study period (dividends reinvested, of course, as well as holding all spinoffs):

Foolish conclusion
Siegel sums it up nicely: "Bear markets are not only painful episodes that investors must endure; they are also an integral reason why investors who reinvest dividends experience sharply higher returns."

This is the essence of what James searches for every day in Motley Fool Income Investor -- stable dividend payers designed to weather any market cycle. If you'd like to try out the service and get the full list of his market-beating recommendations, you can do so free for 30 days. There's no obligation to subscribe.

This article was originally published March 14, 2006. It has been updated.

Rex Moore is no relation to Tyrannosaurus Rex. He owns no companies mentioned in this article. 3M is an Inside Value recommendation. The Motley Fool is investors helping investors.