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.
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