5 ways investors can play defense

Yes, the Dow is flirting with 13,000 again. But these are still crazy days for the economy and the stock market.

Big structural problems are in play -- from the world's $8 trillion debt hole to the specter of 1970s-style inflation, issues we've explored in my recent columns. We've dug a deep hole.

The takeaway: 2012 is shaping up to be a tough year, filled with market volatility, social unrest, political dynamism, a slowdown in corporate profits and a stalling of economic growth.

Efforts to fix the problem have focused mainly on central bank intervention. But with inflationary pressures building, the stage is set for a repeat of the mid-2011 slowdown, which was caused by rising energy prices.

So, what are investors to do?

Simply put, it's time to play defense by moving into large, stable dividend stocks.

No more bonds

In any case, bondholders get lower prices and an interest rate that won't compensate for lost purchasing power or rising default and credit risks.

Right now, 10-year Treasury bonds are offering a 2% yield. After accounting for inflation, that's actually a negative 1% yield. And this assumes that the U.S. government will pay its debt in full despite last summer's downgrade of our AAA credit rating and politicians' lack of meaningful progress in addressing the structural deficit.

Inflation risk worries me most. A negative interest rate is dangerous: It disrupts the natural order of the money markets, twists incentives around and sows the seeds for big-time inflation.

And it also fits with the "financial repression" idea that has the government essentially stealing wealth from cautious bond investors by engineering negative real interest rates to pay down its debt, as it did in the aftermath of World War II -- a subject I explored in July.

Moreover, given the hopeful rebound in some of the economic data and stocks, interest rates should be higher, according to Credit Suisse analysts. The difference between manufacturing orders -- as measured by the ISM new orders index -- and Treasury yields has swelled to the highest level since 2003. (An increase in new orders suggests economic growth is improving, which should push up real interest rates. The fact it's not suggests the bond market is not buying the improvement for some reason. Either it's right and growth will slow again, or it's wrong and bond prices will fall to compensate.)

If my dour outlook is wrong and the economy rebounds, bond prices will fall to push yields back up to close this disconnect. That'll hand even deeper losses to bond investors.

If I'm right, then bonds are now priced to perfection, and the outlook is cautious relative to the outlook for stocks. Given that the market for U.S. Treasury bonds is the largest in the world, one must assume investors have the most accurate information. In other words, they're probably right.

Why dividend stocks?

Clearly, there are big, strategic reasons to avoid fixed-income assets. But there are also a number of reasons to consider dividends as a critical piece of your overall long-term investment strategy.

Historically, 70% of the total return from stocks has come from dividends. This has been even more pronounced over the past 12 years or so, with the Standard & Poor's 500 Index ($INX) now trading near levels first reached in 1999.

Backing up even more, over the past 112 years, U.S. stocks have returned an inflation-adjusted capital gain of just 1.9% a year versus a total return (including dividends) of 6.3% a year. Compare that with the 2% inflation-adjusted return to holders of long-term bonds over the period -- or the 0.9% return on short-term bills.

It's also worth noting that the last time the economy was in shambles and burdened with excess debt, as it is now, was in the late 1940s and early 1950s. The scars from the Great Depression were still fresh. And people were largely ignoring stocks and flocking to bonds.

But all that started to change in 1951. People were pushed out of bonds and back into stocks as the average dividend yield pushed well above what was offered on Treasury bonds.

I think we could see a repeat in the months and years to come. There is certainly the capacity for higher dividends: According to Wells Fargo, dividends equal just 27% of S&P 500 earnings, the lowest in 100 years.

In the postwar years, it was the increased attractiveness and "safety" of dividends that changed the tenor of the investing environment and unleashed the massive 20-year bull market that took the Dow Jones Industrial Average ($INDU) from a low of 161.6 in 1949 to a high of 1,051.7 in 1973, a gain of 551%.

If the past 30 years of the market was all about hot growth stocks, the next era of investing will be all about dividends and income -- making this a long-term thesis.

Continued on the next page. Stocks and funds mentioned include: Southern (SO, news), FirstEnergy (FE, news) and Utilities Select Sector SPDR (XLU)

Risk on, risk off

There are also a number of tactical, medium-term reasons why dividend stocks are worth a look.

For one, Credit Suisse notes that, given prevailing bond yields, dividend stocks should be outperforming fixed-income assets more significantly than they have been. Dividend stocks beat the overall market by 7% over the past 12 months, but the outperformance should've been twice that.

Plus, the reason they haven't performed as strongly as they should has been the tendency for the market to move in big, correlated waves of risk on and risk off. Throughout much of 2011, it was risk off, as defensive, economically nonsensitive stocks outperformed. Dividend issues did well. But over the past few months, it's been risk on, as beaten-down, cyclical, economically sensitive issues have led the way.

It's enough to give you whiplash. Credit Suisse quantifies this by calculating a rotation ratio, which in January stood at 76% -- the highest level since 2001. This means that 76% of the stocks that outperformed last month underperformed in 2011, or vice versa.

If all this feels familiar, it's because something similar happened last year. In January 2011, the rotation ratio was 72% as the risk-off performance of 2010 was reversed.

The historical average, if you're wondering, is 49%.

I'm looking for this risk-on dynamic to reverse once more. Economic momentum has peaked and is moving lower, as indicated by the weak 0.8% growth of gross domestic product seen in the fourth quarter after correcting for a swelling of inventories. New head winds, including geopolitical conflicts, $4-a-gallon gasoline and looming tax hikes and spending cuts, will keep the pressure on.

The strategy team at Barclays Capital, led by Barry Knapp, is also looking for a reversal in the months to come despite central bank interventions, as "it will become clear that global problems are far from resolved, and a correction will quickly follow."

Early warnings signs abound, including a tightening in the market for credit default swaps, a rise in the CBOE Market Volatility Index ($VIX) and the fact the Credit Suisse Fear Barometer (based on S&P 500 options trading) has returned to record highs -- levels last seen during major market tops.

The best strategy for nimble traders would be to move to cash and wait out the storm. Yet that's not a strategy many people will feel comfortable with given years of "buy-and-hold" indoctrination.

The next-best thing is to angle your portfolio toward dividend stocks.

The easiest way to do this is with a dividend-focused mutual fund or exchange-traded fund, such as PowerShares International Dividend Achievers Portfolio (PID, news) or iShares High Dividend Equity (HDV, news).

For individual issues, I prefer the utilities sector, because it's been ignored and is just now stabilizing. Utilities have an element of inflation protection. They appeared to have launched a new period of medium-term relative strength in 2011 before taking a break over past few months, but they now look ready to ramp up again.

My two favorite utility stocks now are Southern (SO, news), with a 4.3% yield, and FirstEnergy (FE, news), with a 5.1% yield. There is also the Utilities Select Sector SPDR (XLU) ETF, which offers diversification protection and a 4% yield.

At the time of publication, Anthony Mirhaydari did not own or control shares of any company or fund mentioned in this column in his personal portfolio, nor has he recommended them previously to newsletter subscribers.

Be sure to check out Anthony's new money management service, Mirhaydari Capital Management, and his investment newsletter, the Edge. A free, two-week trial subscription to the newsletter has been extended to MSN Money readers. Click here to sign up. Mirhaydari can be contacted at anthony@edgeletter.com and followed on Twitter at @EdgeLetter. You can view his current stock picks here. Feel free to comment below.