Taylor On US Markets & Gold
Financial Markets
Sometimes we make investing more difficult than it needs to be. A few years
ago while browsing at a local Barnes & Noble bookstore near my home in
Queens, New York, I picked up a book titled, "Beating the Dow with Bonds,"
by Michael B. O'Higgins, who has made a fortune for himself and his clients
by ferreting out simple investing themes. Michael O'Higgins was the creator
of the "Dogs of the Dow," which simply looked to buy the Dow stocks that
were the weakest the prior year. Even though that strategy was successful,
it didn't compare to a back tested method published in "Beating the Dow
with Bonds." The strategy outlined in that book, which has been influential
in helping your editor form our Model Portfolio, required about 30 minutes
of time per year and a copy of the first issue of "Barron's" each year.
I like to talk about "Beating the Dow with Bonds" at the start of each
year, because of the simple but foundational importance in my own thinking
about how to approach the markets in the new year. Before I review the
investment strategy in this O'Higgins book, let me direct your attention to
the yellow columns in the charts on the left, which outline the phenomenal
success of the O'Higgins strategy. Amazingly, the O'Higgins method would
have turned $1,000 invested in 1972 into $426,709 by the end of 2003. By
contrast, $1,000 invested in the Dow would have grown to a "mere" $34,824,
which includes compounding of dividends. Also, I would like to point out the amazing fact that O'Higgins did so well, not by investing in stocks during the greatest bull market in history, but in bonds! Owners of bonds made huge gains during the years when interest rates collapsed. Note gains of 156% in 1982, 106% in 1985, 45% in 1989, 36% in 1991, 39% in 1993, 85%
in 1995, and 29% in 1997. By earning these gains and then by compounding
them year after year, $1,000 was turned into a modest fortune and a huge
gain in percentage terms over the years. This is a wealth-building model
based on what is really a quite conservative strategy. It was not meant to
be a get-rich-quick scheme, but rather a strategy based entirely on buying
undervalued asset classes while others were largely ignoring them.
How did O'Higgins' method of building wealth over the long term work so
well? More importantly, can it still work? Before I answer those questions,
let me outline the O'Higgins methodology, which requires perhaps one hour
of your time at the start of each new year.
- Check the Earnings Yield for the S&P Industrial Index found on the
Market Laboratory-Stocks page in the Market Week section of "Barron's." The Earnings Yield is simply the dividends and retained earnings for the Index, divided by the value/price of the Index.
- Check the 10-Year Treasury Bonds Ask Yield.
- Compare the S&P Industrial Earnings Yield with the 10-Year Treasury Yield.
- If the Earnings Yield for the S&P Industrial stocks is higher than the
yield for the 10-Year Treasury + 0.30%, you will put 100% of your portfolio
into stocks for the entire new year. Specifically, if you follow O'Higgins
to the "T," you will buy the five "Dogs of the Dow," which means the five
worst-performing Dow stocks during the year just passed. If on the other
hand, the 10-Year Treasury + 0.30% is higher than the Earnings Yield for
the S&P Industrials, you would invest 100% of your portfolio in U.S.
Treasuries.
- If steps 1 through 4 indicate that you should "buy bonds," then we need
to know whether we should buy long-term or short-term bonds. That question is answered by looking at the gold price. If the price of gold is higher on the last day of the year just ended, compared to the last business day of the prior year, then you want to buy one-year Treasury Bills. If, on the other hand, gold is lower this year than last, then you want to buy the
highest yielding U.S. Treasury bonds with durations between 20 and 30 years.
This process is supposed to take place after the close of the current year.
But if we were to go through this exercise at the start of this week, we
would have found the S&P Industrials Earnings Yield of 4.33% and a 10-Year
Treasury + 0.30% of 4.45%. In other words, using the O'Higgins strategy, we would stay out of stocks, and buy bonds.
Would we buy short- or long-term Treasuries? Since the current gold price
is around $440 vs. a price of about $407 last year at this time, we would
buy one-year T-Bills. With this instrument paying about 2.5%, that isn't a
very exciting investment, I will quickly admit, and so employing a strategy
like that may not help people like me sell newsletters. But is it better to
avoid losing big sums of money from your portfolio, or to be excited? I
think the answer to that question is obvious.
Why O'Higgins Works
O'Higgins works because it is value oriented, and as such, avoids buying
assets that are overvalued. It works also because it avoids investing in
risky stocks when they are overvalued and thus prone to big losses, as they
currently are. It also has worked well in the past because changes in the
price of gold have been, at least until the last couple of years, a very
accurate predictor in the direction of interest rates. I believe this is
true because a rising gold price in the past may have indicated rising
inflation, during which time bonds would do poorly. Thus if you were in
short-term bonds, you would avoid big losses when interest rates rise.
Can O'Higgins Work Now?
The accuracy of the gold price to determine the direction of interest rates
has not been as good in recent years as in the past. I believe this may be
due to market manipulation by the Japanese and others who print their own
currency to buy U.S. Treasuries as part of the beggar-thy-neighbor
deflationary dynamics that are very much in play in the current environment.
But there is even one more overwhelming reason why I do not like to rely
too much on the O'Higgins method of investing at this point in time, and
that has to do with the rising systemic risk inherent in increasingly
unbalanced global economic conditions. The data noted above in the
O'Higgins process dates back to just after the Bretton Woods system broke down and we entered into a new floating rate regime rather than the prior gold-based system. It is now becoming increasingly clear that the floating rate system is broken. The only question is how much longer manipulative practices (like printing yen and buying dollar Treasuries) will keep the system together and postpone the Kondratieff winter depression that we talk about almost weekly. The point is, we have a systemic problem, and the O'Higgins process does not allow one to protect himself/herself by opting out of the fiat money system by buying gold.
Will 2005 be the year in which this painful process begins? Your editor is
comfortable with Roger Wiegand's predictions, all of which I think are
within the realm of the possible and more likely "probable." There are
definitely some signs of cracks in the global financial structure. For
example, we are seeing growing resistance by foreigners to finance our
debt. And Roger Wiegand pointed out to me how the Japanese are seeking to
pawn off $1.2 trillion of yen Treasury debt on Americans and Europeans.
This debt is yielding only 1.4% compared to 3.5% in Europe and 4.5% or so
in the U.S. Why would Americans wish to buy this kind of debt? The only
reason I can perceive why big money would buy this low-yielding,
yen-denominated debt is if they expect the dollar to continue to decline,
in which event currency gains would more than offset the loss in yield. But
this kind of pressure on the dollar should also result in higher interest
rates and a decline in the equity, which once again figures to be the
trigger that sends the U.S. equity and housing markets lower-not to mention
psychologically paralyzing American consumers.
Once again the tipping points we will be watching are: (1) Interest rates
and the effect they may have on the housing and equity markets; (2)
Commodity prices with a specific watch on copper, oil, and gas. A sharp
decline in these key commodities should send a signal of a slowing economy;
and (3) Various forms of monetary liquidity, including M-3 and global U.S.
dollar liquidity. If we become convinced that the global economy is heading
into the soup, we will sell our inflation hedges (Rogers Raw Materials Fund
and energy stocks) and focus specifically on gold, gold shares, and our
essential technology stocks, which are geared to reducing the cost of
producing life's essentials.
Gold continues to perform well, as the chart on your left illustrates. The
average price so far in December is $442.88, the 20-month moving average is $394.39, and the 40-month moving average is $352.98. This is proving to be a powerful bull market. Any significant pullback to these longer-term
averages would be possible without signaling an end of the bull market in
gold. Even the "commodity" fundamentals for gold remain highly positive,
and as the systemic problems gain the attention of investors and the media,
I would expect gold to rise dramatically higher. Remember, we continue to
believe that before the current bear market in stocks is over, as was true
at prior major bear market bottoms, the Dow and gold will sell at parity.
Take your pick: $5,000 gold/5000 Dow, or $2,000 gold/2000 Dow. The
absolute values are not as important as the relative values.
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TRADER ROG'S CORNER
TRADER ROG'S CORNER-MARKET EXPECTATIONS 2005
"Prediction is very difficult, especially about the future." -Niels Bohr
(1885-1962)
Gold should find a top in April of 475. From mid-April through May, gold
could sell off to 429 support. By December 2005, we are looking for 500 to
529. If 529 top is broken and closed three times, 650 is within reach. If
we hit 650 by December 2005, gold will quickly pivot and sell off back to
496 support and base there for the next up rally.
Silver should hit a minimum of 8.50 by March. I expect it to move faster
than gold when gold begins to rally again. If so, silver could achieve the
next main top of 9.795 by March. This is doubtful, as gold is still not
showing the strength for silver to follow it that far. In May 2005, we see
a sell off to 7.50, followed by a choppy quiet period. The fall rally
begins in late July or August, continuing on to a December 2005 top of
9.795-10.00. Should silver break 10.00 while running faster than gold and
overshoot, 12.50-15.00 is the next topping area.
U.S. dollar has found its first base at .8105. Today, it likes .8250, and
should stay in the range of .8050 to 84.50 through the first or second week
of April 2005. After April 15, 2005, I expect the dollar to slide rather
quickly to .7750 support in July 2005 (basis US Dollar Index).
Trader Rog's Corner will not be published on Christmas holiday weekend. Our
next newsletter date will be 30-31 of December for an annual wrap-up. Enjoy
the holidays with family and friends, and thank you for being with us in
this marvelous investing and trading adventure.
Best wishes from Trader Rog
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December 19, 2003
Jay Taylor, Editor of J Taylor's Gold & Technology Stocks
www.miningstocks.com
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