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Beating the Dow with Bonds
Market timing and the coming apocalypse
by Ann Coleman (TMF AnnC@aol.com)
Reston, VA (January 19, 1999) -- Michael O'Higgins is a familiar name to most Fools. He is the author of Beating the Dow, the book and the strategy that inspired the original Foolish Four and its brethren and offspring. Beating the Dow also inspired a host of Unit Investment Trusts that sprang up as brokerages and mutual funds tried to cash in on his simple, low-risk method for beating the market.
But a couple of years ago, Mr. O'Higgins shocked both Fools and the Wise by declaring that the market was overpriced and due for a major fall. Instead of stocks, he recommended investing in US Treasury bonds.
Now he has put his advice into a new book, Beating the Dow with Bonds.
Yes, Michael O'Higgins has turned market timer and bear -- a big bear, a Kodiak of a market timer. BTDwBs reads at times like '70s survivalist literature, except that instead of advocating that we all learn how to grow our own food and spin wool, O'Higgins is advocating US Treasury bonds to protect one's investments against the coming market crash.
This presents a bit of a dilemma for Fools. Has Michael O'Higgins joined the Wise?
Foolishness demands an open mind. Of course, an open mind should not be so open that stuff just falls in and clutters it all up. Some judgment must be exercised. That's basically what is going on when Fools summarily dismiss market timers and doomsayers. O'Higgins's book, if nothing else, gives us a chance to reexamine our beliefs. Shaking things up every so often is good -- it lets in air and light and runs off the spiders.
I talked with Michael O'Higgins last week and found him charming and persuasive. Disclosure: I'm a sucker for charm, and in the 70's I studied organic gardening and read books like The Back Yard Hydro-Electric Plant, so I may be overly susceptible to apocalyptic fears.
In an organically grown nutshell, what O'Higgins is predicting is a market crash on the order of the Crash of 1929 or the Nifty-Fifty collapse of the '60s -- not a hiccup like the crash of '87, but the kind of "correction" that can take investors 20 to 30 years to recover from if they bought in at the peak.
He has some impressive statistics to back up his predictions. Perhaps most disturbing is the fact that the price to earnings ratio (P/E) of the Dow (and the Standard & Poor's 500 Index) is far out of line with its historical range. The P/E for the Dow has ranged from 6 to 23 historically, with an average of around 15. (Think of the P/E as the price tag of a stock. It tells you how many dollars investors are willing to pay for one dollar of corporate earnings.)
When the book was written, Dow investors were paying an average of twenty-eight dollars per dollar of Dow company earnings. That P/E of 28 has risen into the low 30's today.
Typically, O'Higgins says, when P/E's get too high, the market corrects until they bottom out. Historically, that bottom has been around 6-7. Even a correction to the historical average P/E of 15 would bring the Dow down to under 5000. A correction to a P/E of 6 would bring it under 3000. Those estimates allow for earnings to continue to grow at projected rates, by the way. In other words, he is not saying that earnings have to decline, but that investors' willingness to pay for the earnings will decline.
Here it is in his own words: "I try to look at everything based on what has happened in the past so that we have a sense of what is possible. Throughout most of financial history, stocks have sold at P/Es from 6 to 28. Of course, now we're off the charts. Between now and 2001, stock valuation and interest rates will return to more normal levels."
"What has caused this? Why are we at 33 times earnings? Because people don't even know we are at 33. We have had a gigantic transfer of responsibility from professionals to amateurs. In the past you had market cycles, but they were contained. When the change from professionals to amateurs first took place, people would invest very conservatively, 401(k)s were in riskless, income-producing investments [Ed: such as government bonds and savings accounts]. Each year, as the market has performed well, more and more money has shifted into stocks. Now many 401(k)s and college funds are 100% invested in stocks. People are borrowing money to invest in the market!
"What took us from 23 times earnings to where we are today was momentum. This run-up has been fueled by amateurs with no training or experience who log on to the Internet. They live according to their experience. People think the market can keep going up forever. That's the same ingredient that propels every market, but supply will overwhelm demand when the price gets out of whack.
"I love stocks. I just don't love their price. If you buy at the wrong time, it can be very painful and very unprofitable. I don't think that most people who buy stock today expect to wait 30 years to get their money back in real, inflation-adjusted dollars. But I think that's what's going to happen."
Asked what might trigger such a collapse, he said, "I have no idea. But something always sets it off. It's normal. The more you put it off, the worse it is in the end. That's the reason you have depressions. Depressions have one common factor: Debt. If you don't owe money, then they can't get to you. If you owe and you need to pay it off, you have to sell something. You get too many people selling stocks and supply will overwhelm demand. Little investors are going to be racing out of the market. Then we are going to swing from spending more than we make to spending less than we make, probably resulting in a major recession or depression."
Scary stuff. There are, of course, arguments to refute worries about a market crash. The U.S. economy appears to be in far better shape than it was in the '30s or late '60s, and in my opinion, investors are not as unsophisticated as O'Higgins believes. The last several market declines have seen institutions selling in a panic while small investors held.
What it comes down to, in my opinion, is that no one can predict the future. Assuming that the market will follow the same pattern that it has over the past 70 years can be just as wrong as assuming that the market will continue to grow for the next ten years as it has for the past ten years. It's good to be reminded of that.
If you are looking for answers, I don't have them. I have only questions. To discuss this issue, please post your comments on our Dow Investing/Foolish Four message board. I won't be able to respond to e-mails on this subject. You can also check out Michael O'Higgins's website at www.ohiggins.com.
Tomorrow: If you buy into this analysis, what's the answer?
Friday: A close look at the Beating the Dow with Bonds strategy.
Fool on and prosper!
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Stock Change Last -------------------- CAT -1 5/8 45.94 JPM -3 1/16 105.94 MMM -1 11/16 72.75 IP -1 5/8 43.38
Day Month Year History FOOL-4 -3.01% -0.06% -0.06% 1.42% DJIA +0.16% 1.89% 1.89% 1.49% S&P 500 +0.70% 1.85% 1.85% 3.24% NASDAQ +2.55% 9.83% 9.83% 11.33% Rec'd # Security In At Now Change 12/24/98 24 Caterpillar 43.08 45.94 6.63% 12/24/98 9 JP Morgan 105.51 105.94 0.41% 12/24/98 22 Int'l Paper 43.55 43.38 -0.40% 12/24/98 14 3M 73.57 72.75 -1.11% Rec'd # Security In At Value Change 12/24/98 24 Caterpillar 1034.00 1102.50 $68.50 12/24/98 9 JP Morgan 949.62 953.44 $3.82 12/24/98 22 Int'l Paper 958.12 954.25 -$3.87 12/24/98 14 3M 1030.00 1018.50 -$11.50 Cash $28.26 TOTAL $4056.95
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