Income investors like owning dividend stocks for a variety of reasons. Not only do they provide valuable income to enhance cash flow, but they also often have defensive characteristics that can help them hold up better in down markets. One draw that the Vanguard High Dividend Yield ETF (NYSEMKT:VYM) has is that it gathers together hundreds of dividend stocks in a single investment vehicle. But before you count too much on the Vanguard dividend ETF providing downside protection in the next bear market, it's important to understand that there's still plenty of stock market risk even in a dividend-focused investment.
Do dividend stocks really protect you from bear markets?
In the past, some sectors of the stock market have tended to do better than others in down markets. In particular, cyclical stocks that are especially sensitive to the ups and downs of the business cycle tend to get whipsawed fairly sharply as the economy switches from expansion to slowdown. In industries in which spending is more discretionary, a drop in the ability to afford goods and services can lead to dramatic downturns in business activity, and that almost always shows up in share prices as well.
By contrast, certain sectors of the economy tend to hold up better even in downturns. For necessities like consumer staples and utilities, consumers have limited ability to change their spending habits even when times get tough. That in turn helps to keep the companies that provide those goods and services more stable, and the fluctuations in sales and earnings tend to be gentler. The result is often less of a disruption to share prices in those sectors.
Interestingly, it's precisely these sectors that often sport above-average dividend yields, and the stocks therefore often show up in dividend ETFs like Vanguard High Dividend Yield. Utility yields tend to be among the highest in the market because regulation limits their growth potential, forcing investors to demand higher income levels in exchange. Consumer stocks are also often mature companies that have less growth potential than upstarts in other industries, and so they tend to reinvest cash flow less often in their business and more often return it to shareholders through dividends.
What we saw in 2008
However, it's important not to overemphasize the impact that this phenomenon can have. As a case in point, consider what happened during the last bear market in 2008. The overall stock market plunged, with the S&P 500 posting a 37% decline that year. The financial crisis took its toll on stocks generally, but it had an especially large impact on the banking sector. Before the crisis, bank stocks were typically solid dividend stocks that had above-average yields, and so they would have been natural candidates for many dividend ETFs to own.
Because of this, dividend ETFs didn't provide much protection from 2008's bear market. The Vanguard High Dividend Yield ETF fell 32% in 2008, and although that was better than the overall market, it still meant a huge absolute decline that shocked many of those who had anticipated more insulation from downward stock market movements.
Why the next bear market could be similar
Of course, 2008 was a special case, because as bear markets go, it was quite severe. Yet there are still reasons to think that the next bear market could provide a challenge for dividend ETFs. Valuations among stocks in defensive industries are unusually high, and that means that there's less of a margin of safety incorporated into their share prices. Historically, dividend stocks have tended to underperform during bull market phases, but that hasn't really been the case in recent years. If anything, investors have gravitated toward dividend stocks, in large part because alternative methods of generating income like bonds haven't really been available due to low interest rates.
Because dividend stocks have done unusually well during the bull market, they could fall more sharply than usual in the next bear market. That doesn't mean Vanguard High Dividend Yield is a bad investment or that dividend investors should avoid it. But if you want to be prudent about stock market risk, the one thing to keep in mind is that you can't count on any stock -- even a good dividend stock -- to provide complete protection from adverse events in the financial markets.