Beating the Dow with Bonds & Gold

Last Month I demonstrated how an investor could have greatly enhanced the performance of his or her portfolio most of this century, by allocating 15% to Homestake Mining Company. Aside from Homestake, our portfolio was comprised of a blue chip portfolio, namely the thirty stocks that make up the Dow Jones Industrials (DJIA). We noted that during the two periods of time this century when stocks entered two of their worst bear markets (i.e., the 1930's and the 1970's), a 15% allocation to Homestake virtually eliminated portfolio losses, even during the darkest days of the Great Depression. Moreover, the inclusion of Homestake significantly enhanced overall returns. The value of allocating 15% to Homestake Mining since 1903 at various milestone dates this century is summarized as follows:

It is difficult to find assets that tend to move counter to stocks. Gold is one of a few that do. The price of gold rose significantly during the 1930's and 1970's when stocks plunged in value. Gold's negative correlation with stocks combined with the fact that the price of mining shares are leveraged to the price of gold is the reason gold shares offer a very efficient form of portfolio insurance against catastrophic stock market declines. For example, an investor who had allocated 15% of his portfolio to Homestake Mining at the beginning of each year from 1929 through 1940 would have suffered a loss of just 1-%. By contrast, an investor who placed his entire investment in the DJIA would have suffered a 45.5% loss. And as shown in Chart I, an investor who allocated 85% to the DJIA and 15% to Homestake Mining at the beginning of each year, from 1903 until the end of 1980, would have enjoyed seeing his portfolio gain 90.1% more than a portfolio comprised only of the DJIA.

Add Bonds for Even Better Returns

Although investing in a gold mining company like Homestake Mining can reduce risk and improve returns, Michael B. O'Higgins has demonstrated that you can beat the sox off of our DJIA & Homestake portfolio. In his latest book titled Beating the Dow with Bonds, (Harper Collins Publishers – 1999) O'Higgins provides a significant amount of data and he explains the logic behind his methodology. Mr. O'Higgins originally gained fame as the creator of "The Dogs of the Dow" theory, in which he illustrated that an investment portfolio could be significantly improved if an investor bought last year's worst performing Dow Jones Industrial stocks on the first business day of each new year. In Beating the Dow with Bonds, O'Higgins has illustrated how, by using bonds, investors can beat the Dow by an even more remarkable margin. As noted below, we have imposed a gold investment on the O'Higgins results to see whether we could further improve on the fantastic results gained by O'Higgins.

I personally like the O'Higgins approach because: 1) it is logical, 2) it represents a value-orientated contrarian approach to investing, and 3) because it is very simple. I must admit that it was upon reading this book that I suddenly opted out of the S&P 500 in favor of U.S. Government Zero Coupon bonds in January and February of this year.

It would be unfair to Mr. O'Higgins to tell you the step-by-step process outlined in his book if you have not purchased it. If you are a serious investor, purchase of Beating the Dow with Bonds is worth every penny of its $24 price. However, even if you do not buy the book you will benefit from it by subscribing to this newsletter because the O'Higgins methodology has become a major input into the shaping our own Model Portfolio. In general the value orientated methodology and logic behind the O'Higgins strategy is the following:

Step 1. - If the ten-year U.S. government T-Bond yields exceed the earnings yield for stocks during the last calendar year, then on January 1st of each year, you begin the new year owning bonds rather than stocks. Earnings yields are simply equity earnings divided by the price of equities. O'Higgins uses the earnings yields for the S&P 500.

Step 2. - If Step 1 tells you to buy bonds, you then look to the gold price to determine whether you should buy long term or short term bonds. If the price of gold on January 1 of the New Year is higher than on January 1 of the prior year, you buy short-term bonds. Otherwise, you buy long term bonds.

Step 3. If the earnings yields on stocks exceed the yield on 10-year U.S. government T-Bonds, then you buy stocks on January 1. Applying the O'Higgins "Dogs of the Dow" model you would buy the five worst performing Dow Jones Stocks of the prior year. The logic behind the Dogs of the Dow? Because these are Dow stocks, they are high quality companies, which you are buying at low, out of fashion prices.

Huge Gains from the O'Higgins Model

Chart II on the opposite side of this page illustrates an enormous advantage using the O'Higgins model. If one had applied this process since 1971, he would have beaten the sox off of the Dow. Unfortunately, we do not have data going back to 1903 as we did for our study of the effects of Homestake on the portfolio returns of the DJIA. But the results of the highly intuitive O'Higgins model are nothing short of phenomenal. A glance at Chart II tells the reader that $1,000 invested in 1971 in the DJIA only would have resulted in a value of $10,324 by the end of 1998. Not too bad. But by comparison, that same $1,000 initial investment in 1971 would have multiplied to $171,284 by December 31, 1998 if the O'Higgins "Dogs of the Dow" approach were applied. Even more astounding, a $1,000 investment in 1971 would have exploded in value to $374,831 by the end of 1998 if a combination of the Dogs of the Dow and the New O'Higgins approach had been followed. Is this believable? I think so because the figures are based on historical fact.

Can a superior performance of this magnitude be sustained in the future? Probably not, especially when, as one would expect, masses of investors begin following the O'Higgins "value investing" approach. Also, O'Higgins gains in long-term bonds benefited greatly from extremely high interest rates during the 1970's and 1980's. However, given current market insanity, when the trend of the day is "momentum investing" rather than value investing, I believe there is an enormous opportunity to "beat the market" by following the O'Higgins model. Accordingly, I have begun using this tool as a major input in shaping the Model Portfolio as it appears in this letter.

Chart II O'Higgins Performance Chart

What was especially shocking to me was the fact that during the greatest bull market ever in stocks, from 1982 until the present, O'Higgins stayed out of stocks! Yet as seen above, he beat the Dow handily. The only time since 1971 that O'Higgins owned stocks (i.e., The Dogs of the Dow) was from 1974 through 1980, just before the great bull market began!

In fact, O'Higgins has, through his work disproved a modern day myth being sold by Wall Street to the masses, namely that the only logical place to invest your money is in stocks. What a fib! O'Higgins has demonstrated that value investing makes sense, over the long run - in 18 of 27 years (67% of the time) - by being mostly in bonds, not stocks! And in a few of those years, he did so much better than the Dow that the compounding of those superior returns – many years earlier, led to far superior long term returns. For example, in 1982 his selection of 30-year zero coupon bonds resulted in a 156% gain compared to a DJIA return of 25.79%. In 1985 his model once again told him to buy 30-year zero coupon U.S. Treasuries, which delivered a 106.9% return compared to a robust 32.8% return for the DJIA. And in 1995, his 30-year zero coupon selection provided a total return of 85.11% vs. 36.49% for the DJIA.

What about Gold?

So far, I have ignored the interplay of gold on the O'Higgins model for one very good reason. O'Higgins does include gold in his investment strategy. He cares about gold only in that it tells him whether to own short or long term bonds. What he has discovered is that the price of gold at the end of each year, when compared to its price at the end of the prior year, can provide a very reliable signal as to whether to buy long or short term bonds. In fact, using this model, gold correctly steered investors into short- or long-term bonds in 28 out of 29 years or 96.6% of the time! As O'Higgins points out, there is not an economist in the world that can beat that tack record.

But what about gold as an asset alternative? We certainly created a case for owning the yellow metal last month as discussed on page one. Might it be possible to further improve on the great performance of the O'Higgins model. The answer is "Yes, most of the time, but not always."

To find the answer to this question, I examined the performance of the International Investors Gold Fund. This fund was chosen rather than using data from Homestake Mining or another major gold mining firm for at least two reasons. First, a gold fund can be expected to provide less risk through diversification. Secondly, the International Investors Gold Fund was about the only gold fund in existence dating back to 1971 from which date the O'Higgins data is available.

In Chart II, on the previous page, the right most column displays the value of a $1,000 investment, 85% of which is invested in the O'Higgins model and at the start of each year, 15% is allocated to the International Investors Gold Fund. As the data illustrates, from 1971 until 1995, even the enormously successful O'Higgins model would have performed even better with a 15% allocation to International Investors Gold Fund. In 1980, when gold briefly exploded to $850 per oz. from its $35 fix nine years earlier, a 15% allocation to the International Investors Gold fund would have resulted in a portfolio worth 40% more than the enormously robust O'Higgins portfolio. However, in recent years, with the price of gold declining to levels not seen in real terms since shortly after gold was set free from its $35/oz. fixed price (i.e., the mid 1970's), owning this gold fund (and any other gold fund?) lowered portfolio returns.

Chart III Gain/Loss from Gold Exposure

But Don't Sell Gold Short

Most investors, including investment professionals, will argue that gold's performance during the past four years proves that "gold is dead," to which I would reply "I heard that one before." In 1968, for example, when market forces were pushing gold above $35/oz., our government officials were selling the same spin as Wall Street and President Clinton are selling now. In 1968 under President Johnson, the U.S. sold gold aggressively in an unspoken effort to drive gold from the minds of investors. Why? The answer is simple. If gold can be eliminated as a superior form of money, politicians will have destroyed a major competitive threat to their ability to print money used to finance pet projects and buy votes. President Johnson's efforts to destroy gold failed. So will the current efforts of President Clinton and other heads of major governments around the world. For the time being, the massive gold sales and gold leasing programs may seem to be working in favor of the politicians and Wall Street. But one day, perhaps soon, this effort will fail. Why? Because the value of gold, unlike paper money, is not dependent on some one else making good on a promise to pay. Unlike paper money, gold is not some one else's liability. The value of gold cannot implode as all paper currencies throughout history have when the economic dominoes began to fall. This is the reason gold will ultimately outlive the U.S. Dollar as a currency of choice by the people.

Keep the Party Going. But when the Music Stops….?

I take it as a given that Wall Street and our politicians will try to keep the game of "musical chairs" going as long as possible. The manipulation of gold toward that end may last for quite a while longer. Only the Almighty knows when it will end. But when the music stops, I want to own gold, because as demonstrated during the 1930's and again in the 1970's, investors who were positioned in the yellow metal and gold shares saw their portfolios suffer only minimal damage. There should be no doubt that with stocks being the most overvalued in history and with debt levels greater than ever before, gold is more needed now as a portfolio insurance policy than at any time this century, including 1929!

The End Might Be Quick & Furious for Equities Markets, Democracy & Freedom

The importance of gold in this letter centers on its use to optimize investment returns. But what few people these days understand is how this natural and honest form of money protects individual liberty. Nor do most people understand how the use of fiat currency by the rich and powerful to reallocate still more of this world's riches to the 1% of Americans who own 50% of the stock market. One day we will all wake up to the fact that our government's spin machine and printing presses have been used for the destruction of democracy and free enterprise. When we working stiffs wake up to this fact, it may be too late to save democracy. In all likelihood, it will be too late to opt out of paper into gold. Given the enormous levels of liquidity created by government printing presses, the price of gold could skyrocket to many thousands of dollars per ounce in a matter of days if not hours as millions of common folks suddenly realize our currency system is built on hot air, not real value. But wait until that realization becomes common to buy gold and it will be like trying to squeeze through a 2 ft. wide door along with thousands of other people trapped inside a burning building. Because there may be little time to react to financial panic, we continue to recommend investors allocate at least 10% of their portfolios to quality gold shares and/or a mutual fund like the International Investors Gold Fund or The Midas Fund NOW! Take your position in gold now when you can buy all you want peacefully and at the lowest price for gold (in real terms) since the 1970's. Let the momentum players chase Internet stocks all they want. History is on the side of the value investor. Buy gold and bonds now. Both are cheap. Both are out of fashion. Now is the time to buy these assets and to stay away from the current market mania which most certainly will end in financial ruin for millions of investors.