5 Stocks to Build Wealth in a Dead Market

At the beginning of the year, I wrote a piece suggesting that dividend stocks are a "must-own" now, based on three arguments, one of which was that we are presently in a "range-bound" market, in which stock prices tread water over a long period without displaying a long-term trend.

It's worthwhile to explain this argument at greater length, because I think its significance is misunderstood. Unless investors harness the power of dividends, they're likely to earn poor returns from their U.S. stock portfolio over the next few years. Here's why.

Are we in a range-bound market?
This is difficult to say with absolute certainty, but there are good reasons to think we are. For one, range-bound markets aren't uncommon: By some measures, they cover more than two-thirds of the last 140 years of market history! This is probably difficult for most investors to grasp because most of their investing experience is coincident with the massive bull market that began in 1982.

The long wait
After bubbles collapse -- which is where we are now -- markets can take a very, very long time to recover their previous highs. These periods allow stocks to "grow into" the valuations they had previously achieved purely as a result of speculative excess.

Consider that the stocks of Coca-Cola (NYSE: KO) and Cisco Systems (Nasdaq: CSCO) are flat or lower compared to their year-end 1999 prices despite their earnings per share having better than tripled since then! Using closing prices for the Dow Jones industrial average, the following table illustrates just how long these "waiting periods" can be:

Source: Dow Jones indexes.

Dividends: From substitute to star player
In such range-bound markets, dividends play an absolutely vital role:

*The price return and dividend do not sum to the total return because of the geometric interaction between the components. Source: Active Value Investing: Making Money in Range Bound Markets, Vitaliy Katsenelson (2007).

Dividends contributed 90% of stocks' total return!
The data are clear: In a bull market, price gains dwarf dividends, with the latter only contributing about one-fifth of stocks' total return. However, in range-bound markets, which are characterized by weak price returns, that contribution expands dramatically, to approximately 90% of stocks' total return.

Thus, ignoring the impact of dividends in a sideways market vastly understates investor returns. For example, while it took the Dow more than 25 years to recover its 1929 high, data from Ibbotson Associates (a division of Morningstar) show that investors who placed a lump sum in the broad market at its 1929 peak would have broken even on an inflation-adjusted basis in late 1936.

(This is not all due to the dividend return, as deflation also played a role, but there is no question that dividends had a significant impact on shortening the "total return" breakeven period: According to data compiled by Robert Shiller, in June 1932, the dividend yield on the broad market was nearly 14%!)

The bottom line
Let me summarize the argument here: We are now in a range-bound market. Therefore, investors should expect weak stock price gains, while dividends contribute the lion's share of total returns. In that context, investors should tilt their stock portfolios toward high-dividend stocks that pay a sustainable dividend. Here is a list of five stocks that I think fit into that category:

Source: Capital IQ, a division of Standard & Poor's.

Putting dividends in a portfolio context
Hopefully, I've convinced you that you should make dividend stocks a part of your portfolio. But let me be clear, "a part of" isn't the same as "all of" -- the decision should be made in the context of your broader portfolio. Nobody knows how long this range-bound market will last, so it makes sense to have exposure to other segments of the market rather than putting all your eggs in the same basket.

This is the same philosophy behind the Motley Fool's Million Dollar Portfolio, a real money portfolio that seeks real wealth appreciation by owning only the best stock recommendations from across The Motley Fool's different services. If you'd like to find out more about putting this "best of breed" approach to work for you, enter your email address in the box below.

This article was originally published April 1, 2010. It has been updated.