The Stock Market Just Flashed a Warning Signal That’s Been Right 83% of the Time Since 1960. Here’s My Plan.

Investors are borrowing heavily against their portfolios to boost their returns. Over the past year, margin debt has increased by 49%. That's a bad omen. According to Fundstrat Global Advisors, whenever margin debt has grown more than 45% year-over-year since 1960, the market has declined five out of six times (83%). That's a signal worth watching.

However, while the market is flashing a warning sign, I'm not panicking. Instead, I'm making an action plan to position my portfolio to better weather a potential market storm and capitalize on opportunities that may arise.

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The warning signs abound

Fundstrat found that surging margin debt has historically preceded a market decline. The firm found that the median performance of the S&P 500 (SNPINDEX:^GSPC) following a 40% surge in margin debt is a 4.2% decline over the next 12 months. They also found that the more margin debt rises, the worse the market's subsequent returns over the next 12-month period. One factor is that investors need to quickly unwind their margin debt when the market starts declining, which exacerbates selling.

This signal isn't the only one flashing these days. The CAPE ratio recently hit its second-highest reading on record. Meanwhile, stocks have historically fallen after the Federal Reserve begins a rate-hike cycle (it recently raised rates for the first time in three years).

My action plan

While these warning signs aren't making me bearish, they are making me more cautious. That's why I've been building cash by selling some lower-conviction holdings and being more selective in new investments. I'm focusing on less volatile options, such as high-quality dividend-paying stocks, especially those with long track records of dividend growth.

Data from Ned Davis Research and Hartford Funds shows that dividend growers deliver the highest total returns with the lowest volatility compared to companies that don't grow their dividends and those that don't pay dividends. My favorite way to invest in the highest-quality dividend growth stocks is through the Schwab U.S. Dividend Equity ETF (NYSEMKT:SCHD). The fund holds 100 top dividend stocks screened by several quality characteristics, including five-year dividend growth rate, current yield, and financial strength. The ETF currently offers a 3% yield (based on its trailing 12-month distribution rate) and holds companies that have increased their dividends at an average annual rate of more than 9% over the past five years.

The Schwab U.S. Dividend Equity ETF's holdings are a who's who of top dividend stocks. For example, its second-largest holding is Procter & Gamble (NYSE:PG) at a 4.3% weighting. The consumer household products giant has increased its dividend for 70 straight years. That more than qualifies it as a Dividend King, a company with 50 or more years of annual dividend increases. Procter & Gamble currently offers a dividend yield approaching 3%, about three times higher than the S&P 500 (1% yield).

I like P&G's durable qualities so much that I recently added it to my portfolio even though I have some exposure through SCHD. Its combination of durable revenue, attractive valuation, and currently high yield makes it an ideal defensive holding for times like these. Meanwhile, because of its low valuation and high yield, P&G doesn't need to grow very fast in the future to deliver a compelling total return over the long term. It offers a blend of lower-volatility ballast during downturns and ample long-term upside potential.

I'm taking the signals seriously

I've been an investor and financial writer long enough to know that it's nearly impossible to accurately predict where the market will be a year from now. However, there are enough signals these days to warrant caution, which is why I'm getting more defensive with my portfolio by trimming some lower-conviction positions and focusing on investing in dividend growth stocks broadly through additional investments in SCHD and more targeted by adding high-quality names like P&G. While this won't make my portfolio immune to a market sell-off, it should help cushion the blow without giving up much upside during an eventual recovery. Meanwhile, cash from lower-conviction sales and dividends will provide me with additional capital to shop if there's a meaningful market decline over the next year.

Matt DiLallo has positions in Procter & Gamble and Schwab U.S. Dividend Equity ETF. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.