Last week we examined the question of whether it was too early for investors to rotate back into growth stocks. In mid-August, the sentiment of a sub-set of active, mainly shorter-term investors polled by the Hulbert Nasdaq Newsletter Sentiment Index had hit record levels of bullishness on growth stocks following two months of gains between mid-June and mid-August.

The presumption appeared to be that the bear market in place since the start of the year had run its course and stock markets were returning to growth. Our argument was that was most likely overly optimistic for several reasons:

• Bear markets often feature rallies that interrupt the broader downward trend. There were 7 during the 2007-09 bear market and 6 during the dotcom crash slump between 2000-03. The two-month rally to the end of August was the first sustained period of gains since the onset of the bear market in late February.
• We’ve only recently come off the peak of the longest bull market in history.
• The average CAPE (cyclically adjusted price/earnings ratio) of S&P 500 constituents is still around 28, which while down from a peak of 38 at the height of the bull market is still high. S&P 500 valuations recovered from an average CAPE of 12 in 2009 which would suggest valuations need to drop significantly lower before there is the foundation for a new, sustained bull market.
• Inflation doesn’t look likely to drop back to target levels any time soon and recession is expected to hit most major economies towards the end of this year and could last until 2024.

None of that means investors should necessarily avoid high-quality growth stocks or the growth-centric Nasdaq index. It’s about as certain as possible that several years from now growth stocks will again be in a bull market. And if history repeats, as it usually does for equity markets (at least on a macro level), markets will eventually recover to set new highs and that growth will be predominantly driven by growth stocks.

As nobody knows with any certainty when the market will bottom and move back into a long-term bull trend, investors with a long horizon of 10 years or longer shouldn’t worry too much about what happens over the next several months or couple of years. As long as growth stocks are eventually worth more than they are now, which they are most likely to be, buying now should deliver solid returns even if there are temporary losses in the meanwhile.

But while long-term investors who are content with their overall strategy and the quality of the holdings in their investment portfolio may prefer to keep it simple and not react to the current bear market, there are also arguments against ‘buying the dip’ too early.

In a recent analysis by markets data company Morningstar, Dan Suzuki, deputy chief investment officer at Richard Bernstein Advisors comments:

“Many investors insist on buying early so that they can be there at the bottom. In seven of the last 10 bear markets, it has been better to be late than early.”

Suzuki says that buying back into growth stocks later rather than earlier more often than not improves long-term returns by reducing downside potential. It also gives investors more time to take informed decisions about the health of previous growth leaders heading into a new bull market. The companies that led the previous bull market may well not be the same lineup as lead the new cycle.

While the performance of individual stocks is not overly important if investors are buying into an index like the Nasdaq whose constituents change through time anyway, it is something to consider when it comes to taking bets exposed to a single company. Data crunched by Suzuki’s company suggest that portfolios that invest back into growth stocks within six months of a market bottom outperformed those that were fully invested throughout the bear cycle.

It is certainly not a bad thing for investors with a long-term investment horizon and no plans to draw down from their portfolio to ignore the current bear market and to keep on investing in the way they were during the bull market. Sometimes keeping things simple is a perfectly valid strategy that avoids the risk of the mistakes that can be made when chasing optimal results.

But the data presented by Mr Suzuki also suggests that investors whose portfolios are heavily weighted towards growth stocks might use this bear market to diversify into income stocks.

Recent research by Goldman Sachs quoted by MoneyWeek shows that income stocks that pay strong dividends historically do better than the wider market during periods of high inflation, defined as higher than 5%. The conclusion was drawn by examining data from the S&P 500 index stretching back to 1940. During the 1970s, a period of sustained high inflation in the USA, the S&P 500 returned a total of 77% and three-quarters of that was down to dividends and their reinvestment for compound returns.

It’s important to note that the economy has changed since the 1970s and the nature of the companies that make up the S&P 500 and other major indices are not the same. The internet era opened up the possibility for the kind of scalable companies based on high-margin digital products that didn’t exist half a century ago. Much of the growth of the last bull market was driven by those companies.

However, there are also still many parallels with historical cycles. Bull markets are always driven by growth companies rather than dividend stocks that look unexciting when capital growth in the solid double figures is being achieved year after year by growth stocks. But dividend stocks are also usually the kind of ‘boring’ businesses that suffer less when consumers are spending less or inflation limits their discretionary purchases.

And if income stocks are both delivering strong dividend returns and capital returns because investors are attracted to them when growth stocks are in the doldrums, they can be a great way to cushion the impact of a bear market.

Even in a lower inflation environment, the Goldman Sachs research shows the importance of exposure to income stocks over the long term. Over the past two decades, dividends and their reinvestment for compound returns have driven about half of the MSCI AC World Index’s total returns.

Yes, investors would have made more being purely invested in U.S. growth stocks via the Nasdaq index over the same period but there is no guarantee that will be the case over the next two decades. Putting all your eggs in one basket that has previously performed well is a famously bad investment strategy.

With that and the current high inflation environment in mind, as well as the likelihood of a recession some analysts are now tipping to last until 2024, investors might consider a rotation into dividend stocks while the current bear market lasts. Especially as the evidence suggests there is a good six-month window to rotate back into growth stocks when markets return to a long-term bull trend.

It stands to reason that especially dividend stocks that look well positioned to absorb inflation by passing on higher expenses to their customers would be of particular interest. Five highlighted by MoneyWeek that look like they meet that description are:

Diageo

When it comes to pricing power, the FTSE 100 alcoholic beverages and spirits specialist Diageo looks particularly well positioned to pass on increased costs to end consumers. The company’s portfolio, which includes brands like Guinness, Johnny Walker whisky and Smirnoff Vodka has well-diversified exposure to a range of price points and international markets.

It already has very strong gross profit margins thanks to its economies of scale and buying power and despite that is better able to increase retail prices of its products to maintain them. Diageo doesn’t offer a big dividend yield at 2.2% but it looks safe, could well be boosted further and capital gains, even during a broader bear market, are a realistic possibility.

Glencore

A dividend stock that even leans into inflation rather than holding it at bay is Glencore, the miner and commodities trader. Soaring commodities prices are one of the main drivers of the worrying levels of inflation currently being experienced and Glencore is benefitting greatly. Most commodities companies are but Glencore’s scale and access to capital and information beyond most rivals put it in an even stronger position.

Glencore expects to earn $3.2 billion trading commodities this year and the longer market disruption keeps prices high and volatile, the longer it will be able to keep banking profits that have recently been vastly inflated compared to historical norms.

The company also has a history of returning excess profits to investors when it doesn’t have a strong case to invest them otherwise and they are expected to keep coming back in the shape of big dividends this year and next. Analysts expect a dividend yield of 8.9% this year at Glencore’s current valuation and 8.5% next year. Share buybacks are also a distinct possibility.

This could be a stock to buy now and then potentially move out of when commodities markets start to show signs of returning to normal.

Severn Trent

Utility companies are traditionally seen as defensive stocks which come into their own in precisely rocky economic times like these. They are generally unexciting but steady and can offer reliable dividends. One London-listed utility that stands out is water and waste company Severn Trent.

It benefits from an inflation-linked recurring revenue stream from households and businesses and its infrastructure assets will grow in value as inflation pushes up prices. Severn Trent’s net debt will also fall in real terms as a result of inflation and 60% of its 69% net gearing is tied to fixed rates.

The company is prevented from raising prices freely by the regulator but it will allow it to compensate for inflation and it is innovatively now accounting for 50% of its energy needs through self-generation. That should free up cash for Severn Trent to continue to increase its dividend, which currently yields 3.6%.

Phoenix

Pensions company Phoenix is a less obvious income option than larger section peers like Aviva and Legal General but could be a hidden gem for dividends. It is more specialised than most of its peers and doesn’t offer general insurance products, only pension policies and long term savings products.

That lack of diversification could be seen as a weakness but Phoenix also has many strengths. It has grown in size by acquiring the books of closed pension policies other companies have been keen to sell and now manages around £270 billion in pension assets for around 13 million policy holders.

This provides Phoenix with a steady, predictable cash flow and it keeps down costs by outsourcing the management of the assets its book holds. It has also hedged its business against inflation well with investment managers mandated to deliver predictable returns and its most recent results showed the current economic environment hasn’t hurt its financial performance.

Management thinks the company can generate £17 billion in cash over the next several years and when expenses and costs are stripped out that is expected to mean £12 billion left to return to shareholders. Some of that could be funnelled towards further acquisitions but a dividend yield of 7.9% currently, with more quite possibly to come, makes Phoenix a potentially very attractive under-the-radar income stock.

Primary Health Properties

A REIT focused on health service properties mainly rented to the NHS looks like a safe bet over a rocky economic period. Secure, repeat revenue, most properties have contracts that include 5-year rent reviews, and assets growing in value let to mainly government agencies look like as strong hedge against inflation as realistic. And the stock currently offers a yield of around 4.6%.