Source: Flickr user Rafael Matsunaga.
To say the stock market has had a good run since hitting its lows in March 2009 would be quite an understatement. Industries across the board have seen strength at one time or another, with select companies seeing fivefold, tenfold, or even 20-fold gains.
Behind this market strength has been a steadily improving U.S. economy. The domestic unemployment rate has fallen considerably from its October 2009 high of 10%; housing prices, which had put a number of homeowners underwater, have rebounded; manufacturing and factory output continue to grow; and consumer confidence generally remains high.
Source: Flickr user thetaxhaven.
Is the stock market going to plunge?
But we also know that the stock market can't go up forever. A number of worrisome factors could ultimately derail the overall market. First, the end of the Federal Reserve's economic stimulus, which involved buying long-term U.S. Treasuries and has been at least partially responsible for holding lending rates down, has the potential to boost lending rates and slow consumption, as well as home buying.
Second, the quality of new jobs being created could arguably be described as suspect. As the labor force participation rate has decreased due to a large demographic shift caused by baby boomers retiring, the number of nonfarm labor employees has only slightly increased since 2007. In addition, many post-recession jobs are part time in nature, which can make it tough for those workers to pay their bills.
Finally, a number of publicly traded companies have repurchased a substantial amount of their own stock, which boosts their earnings per share. This strategy has masked a potential lack of organic growth for these companies. Long story short, share repurchases and cost-cutting aren't a long-term solution to business growth.
Three things you should do right now
So is the market about to plunge? Possibly, but whether that happens in two days, two months, or two years isn't what's really important. Here are the three actions you should consider taking immediately regardless of where the market stands now.
1. Accept it
Investors should first accept that market plunges will happen, whether we want them to or not.
Regardless of whether you're working with $500 or $50 billion, the dollar value traded on a daily basis via U.S. stock exchanges dwarfs your investment portfolio, meaning your effect on the overall market as an individual is small.
Since 1960, the Dow Jones Industrial Average (^DJI -1.17%) has declined by at least 20% on nine separate occasions. According to the Pring Turner Capital Group, bear markets over the past 54 years on average have lasted 15.4 months, with the Dow Jones index declining an average of 33.1% during those declines. While the prospect of seeing one-third of the Dow's value evaporate might lead to temporary indigestion, investors who have stayed invested in the stock market since 1960 have also seen the blue-chip index rise by more than 2,400% during that same time span.
2. Diversify with quality dividend-paying stocks
Secondly, if you aren't already doing this, you should consider hedging your downside risk by investing in high-quality stocks that pay a dividend.
Source: TaxCredits.net via Flickr.
This type of stock serves a dual purpose during a stock market downturn. First, dividend stocks generate monthly, quarterly, semiannual, or annual income that can help offset their potential paper losses. Dividends aren't just for retired people, either. Dividend income can be compounded and reinvested over time by younger adults and is an excellent source of long-term wealth creation, even during a bear market.
Further, the capacity to pay dividends serves as an indicator to investors that a business is healthy and cash-flow positive. Investors can assess a company's dividend health by examining its payout ratio (i.e., how much of its earnings per share it pays out as a dividend), as well as its payout history to determine whether there's a sustainable growth trend.
What are some examples of high-quality dividend stocks, you ask? Any company that provides a basic necessity is a great starting point, because these companies aren't affected much, if at all, by economic downturns. Beverage maker Coca-Cola (KO 0.58%), water utility company American States Water (AWR -0.30%), and healthcare giant Johnson & Johnson (JNJ -1.27%), for example, all have yields in excess of 2%, have boosted their annual payouts for more than 50 consecutive years, and provide goods and services that are in demand during all economic environments.
3. Keep investing
Lastly, and perhaps the most important point worth making, is that you shouldn't stop investing even if the stock market "looks" as if it has gotten ahead of itself.
Timing the market with any consistency over the long term is practically impossible, so sticking to the sidelines could cause you to miss out on substantial gains that ultimately could mean a big difference when it comes to your retirement. If you don't believe me, the point is illustrated by the following data on the S&P 500 (^GSPC -0.73%) between Dec. 31, 1993, and Dec. 31, 2013:
Graph by author. Source: J.P. Morgan Asset Management, using data from Lipper.
As you can see above, if you tried to time the market and happened to miss out on the S&P 500's 60 best days over this arbitrary 20-year period, your $10,000 investment would be worth $4,073. That's right: You'd have lost nearly 60% of your money! If you missed even the 30 best trading sessions over the past 20 years, your return would be just 19.8%, or an aggregated 0.9% per year.
However, if you stayed invested for those 20 years, throughout the dot-com bubble and the worst recession witnessed in seven decades, your investment would be up by 483%. Note that if you even missed the 10 best market days, your investment returns were more than halved to just 191%. The point here is simple: stay invested and think long-term.
