Beating the Dow with Bonds

Most of this is copied from a previous post – Dogs of the Dow. However, the indicator finally switched away from stock.

In Beating the Dow with Bonds, Michael O’Higgins describes his simple risk-averse strategy that has three different investments (stocks, US government bonds, T-bills), indicators and decision points along with an excellent track record

O’Higgins is pretty clear about how to determine when the Dow stocks or Bonds are indicated, so that is a big help in this project.

Turn the P/E ratio upside down, putting the earnings on top and the share price on the bottom, and you get something called the earnings yield. That makes it easier to compare with the interest yield one can get from bonds, which compete with stocks for investors’ favor.
Investing: A simple plan, but hard to follow

This is process O’Higgins describes with examples – then and now

  1. S&P earning yield: 5.69 (P/E 17.59) Jul 10, 2006
    5.53 (P/E 18.08) Jun 13, 2007

  2. 10-year US Government T-bond yield to maturity: 5.18% Jul 10, 2006
    5.26% Jun 13, 2007
  3. estimated 10-year AAA corporate bond yield [10-year US Government Y-bond yield to maturity + 0.30%]: 5.18 + 0.30 = 5.48
  4. difference [S&P earning yield] – [estimated 10-year AAA corporate bond yield] : 5.69 – 5.48 = 0.21 Jul 10, 2006
    -0.03 Jun 13, 2007 ***
  5. current Gold price per troy ounce – use bid price (KITCO): $649.90 Aug 4, 2006
  6. one-year change in Gold price (KITCO): +211.20 +48.29% Aug 4, 2006
    15.56% Jun 13, 2007</li>

O’Higgins’ rules

  • STOCKS are the asset class of choice if the S&P earnings yield EXCEEDS the calculated estimated 10-year AAA corporate bond yield
    or the difference between the S&P earnings yield and estimated 10-year AAA corporate bond yield is POSITIVE
  • T-BILLS due to mature a year from now – if the one-year change in the price of gold is POSITIVE (higher than the price a year ago)
  • T-BONDS if the one-year change in the price of gold is NEGATIVE (lower than the year-ago price)
    highest yielding U.S. Government zero coupon bonds available to mature in twenty years or more

The story so far…

2006.7.10 – stocks (+0.21)
2007.4.20 – stocks (+0.63)
2007.6.14 – T-Bills (-0.03)

2013.9.2 – stocks (5.13 – 3.04 = +2.09, gold -17.30%)