As Key Global Markets Stumble, Gold and Dividend Stocks May Keep Investors on Course

[Editor's Note: The U.S. stock market – and the Money Morning editorial office – is closed for the Memorial Day holiday today (Monday). But we'll resume our regular publishing schedule tomorrow (Tuesday), with a look at the week ahead, a look at investment plays in the solar-energy field, and several other reports.]

By Jason Simpkins
And William Patalon III
Money Morning Editors

Is the hoped-for economic rebound merely a mirage?

And if it is, how should you play it?

For the past few months, optimistic analysts and investors have been scouring the global economy for so-called "green shoots" – a new financial buzzword that refers to any early indicators of a financial recovery.

Investors believe they've seen enough evidence that the U.S. economy may be bottoming out to ignite one of the strongest stock-market rallies in years. After closing at a 12-year low on March 9, the Standard & Poor's 500 Index has soared 32%. The  Dow Jones Industrial Average has zoomed more than 27%, and the tech-laden Nasdaq Composite Index has rocketed 34%.

In a March 15 interview on the CBS show, "60 Minutes," U.S. Federal Reserve Chairman Ben S. Bernanke said the United States escaped a repeat of the 1930s Great Depression. The economic downturn would hit bottom this year, with an actual recovery starting in 2010.

"And I think as those green shoots begin to appear in different markets, and as some confidence begins to come back, that will begin the positive dynamic that brings our economy back," Bernanke told viewers.

But now those "different markets" appear to be sending some troubling signals.

Green Shoots Yield to Red Ink

Last week, Mexico reported that its economy contracted at an annualized rate of 21.5% in the first quarter. The report followed equally dismal reports from Japan, Germany and the United States. Japan – the world's second largest economy – said its gross domestic product (GDP) contracted at a 15.2% clip, its worst performance since 1955. Germany's economy shrank at a 14.4% annualized pace, its worst showing since 1970.

In fact, Europe as a whole stumbled in the first quarter, as economic activity in the 16-nation Eurozone fell the most in 13 years. The Eurozone's economy contracted by 2.5% in the three months that ended March 31.

At home, the U.S. economy contracted by a 6.3% annual rate, with the U.S. Federal Reserve predicting "a gradual recovery" that starts in the second half of this year.

If uncertainty continues to be the watchword, how should investors position themselves?

Staying on the sideline may appear safe, but it's actually been proven through research to be a risky strategy. For instance, after looking at S&P 500 returns between 1993 and 2007, Davis Advisors Funds found that investors who remained invested and didn't try and "time" the market ended up being much better off than investors who moved in and out of the market – often missing strong days in the market, as a result, says Wellcap Partners Managing Partner Alan Schram.

Investors who remained invested received an average annualized return of 10.5%. But investors who missed just the best 30 trading days over this stretch saw that return drop all the way down to 2.2%. And the more strong days an investor missed, the worse the returns got, Schram says.

Here's a summary of the results of that study, looking at the investor's action and the average annual returns that resulted:

• Stayed the course: 10.5%.
• Missed the 10 best days: 7.1%.
• Missed the 30 best days: 2.2%.
• Missed the best 60 days: (-3.2%).
• Missed the best 90 days: (-7.4%).

Nevertheless, there's still about $8 trillion sitting on the sidelines – enough to create a sustainable market really should the "green shoots" grow into a full-fledged recovery.

Are Income Stocks the Antidote in a Sick Economy?

OK, so it pays to stay invested – but invested in what? And what if the hoped-for recovery ends up getting blunted? After all, those "green shoots" could easily wither on the vine.
According to Money Morning Contributing Editor Martin Hutchinson, seeking out stocks with high – but sustainable – dividend yields is the perfect strategy for an imperfect market.

Stocks with high-dividend yields are one part of a two-element investing strategy that Hutchinson says can create "permanent wealth" for investors who are willing to follow it through. Gold is the other key part.

Income From Dividends: One Pathway to Permanent Wealth

Dividend payouts are a way that a company's leadership can signal its confidence in the future, Hutchinson says. A company has to have profits and – just as important – cash flow to finance the quarterly payouts, so a company that is maintaining a high yield is basically letting its investors know that it's upbeat about its future.

Management is "basically saying to you that we'll be able to keep paying this going forward," which is a bullish sign, Hutchinson says.

Income is a key component of any investment strategy.

"Dividends create wealth in two ways. First, they provide cash flow that you can either use for living expenses or to reinvest: That means there's no more having to sell shares, often at a depressed price, to meet your monthly bills, or to finance a vacation or home remodeling," Hutchinson says. "Second, if you buy shares with high dividend yields, there's a good chance that the market will eventually notice the superior [dividend] payouts, and revalue the shares so that their dividend yield is back down around the market's average. For a dividend yield to go down in this manner, the stock price has to go up. Once that happens, you have received dividends and capital gains."

While dividends provide income stability, gold provides a hedge against the inflationary pressures that are virtually certain to emanate from the massive amounts of money that the federal bailout and stimulus plans are injecting into the U.S. economy.

The recent surge in the prices of both gold and oil are proof that the markets expect inflation to escalate.

"Gold and gold-based investment – such as gold-mining companies – are an important part of a permanent-wealth-investment strategy because of gold's historic function as a store of value that is impervious to inflation. At the moment, when inflation is low but there is a big danger of it rising, gold investments are an essential protection for permanent wealth investors," Hutchinson says.

[Editor's Note: When Slate magazine recently set out to identify the stock-market guru who most correctly predicted the stock-market decline that accompanied the current financial crisis, the respected online publication concluded it was Martin Hutchinson, a veteran international investment banker who is one of Money Morning's top forecasters.

It was no surprise to our readers: After all, Hutchinson warned investors about the evils of credit default swaps six months before the complex derivatives did in insurer American International Group Inc. Then, last fall, Hutchinson "called" the market bottom.

Now Hutchinson has developed a strategy for investors to invest their way to "Permanent Wealth" using high-yielding dividend stocks. This strategy is tailor-made for an unpredictable stock market that's back-dropped by an uncertain economy. Just click here to find out about this strategy – or Hutchinson's new service, The Permanent Wealth Investor.]

News and Related Story Links:

• iStockAnalyst:
  Green Shoots Of US Economic Recovery.

• AFP:
  Bernanke sees 'green shoots' of US recovery.

• Money Morning Market Analysis:
  What Shape Will the U.S. Recession Take: U, W or ‘Bloody L?'

• Money Morning Market Analysis:
  Is the Stock Market Rally For Real?

• Investment U:
  Sovereign Wealth Funds: $7 Trillion Reasons to Stay Invested.

• Money Morning Special Report:
  Why Dividends and Gold Are the Keys to Permanent Wealth.

• The Huffington Post:
  Timing the Market.