FOOLISH FOUR PORTFOLIO

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Buy Bonds?
To beat the market?

by Ann Coleman (TMF AnnC@aol.com)

Reston, VA (January 20, 1999) -- So, what do YOU think, Fools? Is the market headed for a major correction within the next couple of years, the kind that devalues stocks to the point that it takes decades for investors to recover?

Yesterday, we discussed Michael O'Higgins's new book, Beating the Dow with Bonds, which predicts just such an apocalyptic crash. Today we will look at his recommendations for protecting oneself.

It doesn't take a genius to figure out that if the market is going to crash, you don't want to be in stocks. (The "if" is where the rub lies, of course.) But according to O'Higgins's new system, you wouldn't have been in stocks since 1980. This is rather confounding to those of us who have noticed "The Great Bull Market." According to O'Higgins, though, bonds have been the better buy during that great bull market. Stocks have been overpriced relative to bonds since 1980.

The test for which is the better buy is to compare the earnings yield of stocks with the earnings yield of bonds. If your invested dollar buys more earnings (interest rate yield) from bonds than from stocks, then bonds are the better buy. Apparently that has been the case since 1980. O'Higgins's combination of one year US Treasury bills or 30 year zero coupon US Treasury bonds outperformed the stock market and the original Beating the Dow 5-stock strategy during that time, according to a retrospective test.

So his answer to what you should do to protect yourself is: Buy Bonds. But not just any bonds -- US Treasury, 30 year, zero coupon bonds when the strategy predicts that interest rates will drop, or one year T-bills if inflation is predicted to increase.

The reason the strategy performed so well during this time is that inflation rates, and thus interest rates, have been dropping more or less steadily since 1979, when inflation hit a whopping 13%. There was a 5-year stretch in the late '80s where inflation rose, and a blip in 1996 where we had a pop up, but overall, the trend has been downward. When inflation drops, interest rates drop, and when interest rates drop, bond prices, especially long bond prices, rise. (If that isn't intuitively obvious, click here: Exploring Bonds.)

If you believe O'Higgins's assertion that interest rates should continue to drop, then bonds still have a bit of a kick left in them. He is predicting a 20 per cent return on zero coupon bonds this year.

The strategy's success hinges on switching from long bonds to one year Treasury bills at certain points. This is predicted by the Gold Indicator. Simply put, you check to see if the price of gold has risen over the past year or declined. If it has risen, then the folks who buy gold are worried about inflation. (Folks who buy gold are supposed to have been pretty good, in the aggregate, at predicting inflation.) Inflation is death on long bonds, and not so hot for stocks, so you switch to short term T-bills. If the price of gold is going down, the folks who buy gold are not too worried about inflation, so bonds are your better bet.

The strategy sounds reasonable, and it's not terribly complicated, but it bears a striking resemblance to legions of other market timing systems that have proven to be lovely in retrospect but not so hot going forward. The similarity in itself proves nothing, of course, but it certainly raises some warning flags. That said, the gold indicator does appear to have been very effective (although not perfect) at signaling when one should switch out of long bonds during the last 30 years -- I think. The chart in BTDwB is not that easy to follow.

As he did in Beating the Dow, O'Higgins presents results but no backup data, leaving the numerically intrigued no place to go. If one accepts his results (and I know of no reason not to), the strategy appears to have performed well (although not quite as well and the current RP version of the Foolish Four, I must add).

That was then, though, and this is now. Hindsight makes it easy to construct a strategy that uses bonds to achieve great returns in a period of dropping inflation, especially if you have a magic indicator that tells you when to sidestep the volatile long bond. But with inflation low and bond rates near their historical lows, the future performance of the strategy hinges on interest rate predictions. It's easy to believe that rates will drop if they are at 15%, but will they make another drop, from 5% to 4%?

I'll let O'Higgins make that case: "Long bonds have had a tendency to regress back to 3% over the inflation rate. We're at 1.5% inflation for last 12 months. So a reasonable long bond rate would be 4.5%. A few years ago, the idea that we could get to 5% on long bonds was inconceivable. As we speak, we are at a 5.08% yield. If we were to go to 4.5%, and the spread of T-bills and zeros were to widen, my zeros would go up 22%. [Ed. Note: He refers to US treasury zero coupon bonds affectionately as "my zeros."] I think that's comfortable to do by year end. If we were to get to 1% inflation, and a number of reliable sources are projecting zero inflation in 1999, the interest rate could go to 4% just by returning to the historical relationship between the inflation rate and the long bond rate."

But what if interest rates go up? "You can lose money," he replies. "Wherever you can make money, you can lose money. Zeros [they aren't "my zeros," now] will go down more than a coupon bond. They are roughly twice as volatile as coupon bonds."

A word on zero coupon bonds may be in order here. Most bonds pay interest every six months (In the "olden days," you would send in an actual coupon twice a year to get your interest). Zero coupon bonds pay no annual interest. In effect, all of the interest is paid at the end. That is done NOT by toting up the interest and adding it to the face value of the bond when it is redeemed so that a $1,000 face value bond is redeemed for, say, $2,500, but by discounting, in a rather convoluted process, the original price of the bond. A $1000 zero coupon, 30 year bond might sell for only a few hundred dollars.

Example: If you invested $231.38 today for 30 years at 5% interest and left the interest to compound, in 30 years your original investment would have grown to $1,000.00. So with zero coupon bonds, the original price for a 30 year bond with a 5% yield would be roughly $230.00. In 30 years, the bond will mature and the holder will be paid $1,000.00 by the US government. When interest rates drop, the price of the bond rises. It also rises in the secondary market, so if you bought your 5% bond for $230.00 a year ago and rates have dropped, it could be worth, say, $260.00 today. (Other factors, like the time left to maturity, figure in the pricing, but interest rates are by far the greatest factor when maturity is a long way off.)

Once again we come down to predicting the future. If the market crashes as O'Higgins predicts, then presumably the strategy would put one back into stocks at some point after the crash. In the mean time, he says, bonds are the place to be. But with bonds, you are vulnerable to interest rate fluctuations. If interest rates should not behave as predicted, you could lose money that way, too. Even those gold buyers have been wrong occasionally. Is burying your money in the back yard under an old mattress the only answer?

Again, I invite you to discuss these questions on our Dow Investing/Foolish Four message board. I can't respond to e-mails on this subject, but I've read every post on the boards, and the level of discussion is extremely high. If you have questions after reading the book, you can write to O'Higgins Asset Management Inc. at btdwb@ohiggins.com.

Fool on and prosper!

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Today's Stock Lists | 1998 Dow Returns

01/20/99 Close
Stock  Change   Last
--------------------
CAT  -   3/4   45.19
JPM  +2  7/8   108.81
MMM  -3  1/4   69.50
IP   -2  3/8   41.00
                   Day   Month    Year   History
        FOOL-4   -2.22%  -2.28%  -2.28%  -0.82%
        DJIA     -0.21%   1.68%   1.68%   1.28%
        S&P 500  +0.36%   2.22%   2.22%   3.62%
        NASDAQ   +0.30%  10.16%  10.16%  11.67%

    Rec'd   #  Security     In At       Now    Change

 12/24/98   24 Caterpillar   43.08     45.19     4.89%
 12/24/98    9 JP Morgan    105.51    108.81     3.13%
 12/24/98   14 3M            73.57     69.50    -5.53%
 12/24/98   22 Int'l Paper   43.55     41.00    -5.86%


    Rec'd   #  Security     In At     Value    Change

 12/24/98   24 Caterpillar 1034.00   1084.50    $50.50
 12/24/98    9 JP Morgan    949.62    979.31    $29.69
 12/24/98   22 Int'l Paper  958.12    902.00   -$56.12
 12/24/98   14 3M          1030.00    973.00   -$57.00


                             Cash     $28.26
                            TOTAL   $3967.07

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