The Dow Recession Rebound Strategy: Why You Never Want to Be on the Sidelines

By Jennifer Yousfi
Managing Editor

Miss the recession, miss the rebound.

If there's one set of statistics that underscore why market timing is such a risky undertaking, it could well be this: As much as markets decline during recessions, if you jump out at the bottom, you run the risk of getting left behind when the economy rebounds and stocks do, too. And the opportunity loss on those missed profits can be substantial.

Consider this: January's stock performance is often viewed as an early look at the market performance to come. But that's not foolproof. According to Thomson Financial, the five worst January swoons since 1926 led to an average gain of 12.3% over the following 12 months and 26% over the next 24 months.

According to what we'll call the "Dow Recession Rebound Strategy," the gains coming out of an economic downturn can be even more dramatic than the rubber-band snapbacks from a lackluster January.

For instance, during the Great Depression - the downturn that lasted from August 1929 to March 1933, the Dow Jones Industrial Average plunged 84.2%. But one year later, the blue-chip bellwether soared 81.07%.

Much more recently, the weight of Watergate and unrelated economic problems pushed the Dow down 19.04% from Nov. 1973 to March 1975. But a year later - thanks to the relief rally from the economic rebound and the U.S. withrdawal from Vietnam - the Dow soared 30.11%, for a relative gain of nearly 50%. [For a full analysis of Dow performance during U.S. recessions, and after, please see chart that follows this article].

How Now the Dow?

It goes by many names - the Dow Jones, DJIA, Dow30, or just "The Dow" - but no matter what you call it, the Dow Jones Industrial Average is the oldest and most well-known U.S. stock index. For years, investors have been using the Dow to gauge the health of the U.S. markets. 

At inception, the index created by The Wall Street Journal editor and founder, Charles Dow, contained just 12 stocks. But the DJIA has grown in the past 100 years and is now made up of 30 U.S. blue-chip stocks, some of America's most well-known names. [For a complete listing of the Dow's 30 components, please see the chart that follows this story.] 

To account for the various stock splits over the years, the Dow is no longer a simple average of the prices of its compontent stocks. Instead, the sum of the component prices is divided by a divisor that is adjusted whenever one of the component stocks has a stock split or stock dividend, to generate the value of the index.

Year to date, this bellweather index is down 1,082.69 points, a 8.16% decline as of Friday's 12,182.13 close, and that performance has created market uncertainty that has many experts forecasting a recession. But in contrast to the old adage, "What goes up, must come down," where the Dow's concerned a better maxium might be "What goes down, will come up."

As the U.S. economy has ebbed and flowed, the Dow has taken investors on a bumpy ride. But the wild fluctuations that have given investors a white-knuckled ride throughout the years are the reason that stocks offer such potential for long-term gains.

"Investors should be grateful for bear markets, because without them stocks would offer bond-like returns," Larry Swedroe, a financial advisor with St. Louis-based Buckingham Asset Management, told Fortune.

In fact, the Dow is remarkably resislient. On Sept. 17, 2001, the first day of trading after the 9/11 attacks, the Dow suffered its largest historical one-day point drop. The Dow fell 684.81 points, a 7.1% decline. By the end of that week, the Dow had fallen 1,369.70 points, or 14.3%. But the index recovered and managed to close the year above 10,000.

So while we're not yet in bear territory [the Dow is not down 20% from its Oct. 11 intra-day high], a steady stream of troubling economic indicators makes it likely we're going to keep heading that way. But stay calm. Just remember that bear markets can present unique opportunities to savvy investors.

The Dow has recovered quite well after every U.S. recession and if don't stay invested, you're bound to miss the upswing when it comes - and it will come. You want to be there when it does.

What to Do, When the Dow is Down

Money Morning Investment Director Keith Fitz-Gerald has five tips to help you not only stay afloat, but even profit during a volatile market.

• Plan your exit strategy. "One reason so many investors are getting clobbered is that they're holding on too long," said Fitz-Gerald. Trailing stops in your portfolio can help you protect your principal and your profits during good markets; and they're an absolute necessity in a bear market.

• Focus on income. "By consistently reinvesting dividends during down markets, investors can substantially expand their asset base, which puts them way ahead of the game when markets recover and stock prices soar - as they always eventually do," said Fitz-Gerald. And it's important to remember that dividend-paying stocks tend to be more stable than their non-dividend paying brethren - particularly during rocky stock markets.

• Build in safety. "Allocate up to 50% of your assets in our favorite balanced fund, the Vanguard Wellington (VWELX)," said Fitz-Gerald. Since 1929, the Vanguard fund has captured 80% or more of the market's upward moves [including many of the years where there were market gains of 20% or better], even with a "safety-first" balanced blend that's about 60% stocks and 40% bonds. This asset mix maintains your ability to gain in bull markets, while minimizing your risk during more-bearish trading sessions.

• Look to exports. "A beaten-down greenback means that U.S. companies - particularly those with strong export businesses - are trading for bargain prices," said Fitz-Gerald. With any of these companies - be it sin stocks, gaming firms, or defense contractors - stick with firms that have lower debt, steady sales growth, and that are posting strong earnings. The best plays will be firms with global operations.

• Hedge your bets. "Professional investors hedge with options, futures and other types of derivatives", said Fitz-Gerald. "But you can achieve this far more easily." Take advantage of a specialized exchange-traded funds (ETFs) such as the Rydex Inverse S&P 500 Strategy Inverse Fund (RYURX), which is designed to rise in value by 1% for every 1% the S&P 500 falls.

When it comes to bear market strategies, there's a final - but important - thought to consider. When the markets get rough, don't give into the temptation to cash out and just play it safe. Studies show that investors who stay in the game and pursue profits using strategies like the ones we've just outlined tend to capture the biggest returns over time.

"It's best to buy when there's blood in the streets," Fitz-Gerald said. "Even if it's your own."

News and Related Story Links:

• Fortune:
  Recession? Where to put your money now

• Money Morning:
  Five Survival Strategies That Will Allow You to Profit Even in a Recession