Value Investing and Market Timing - Beating the Dow with Bonds

In "Beating the Dow", Michael O'Higgins tested several mechanical stock picking strategies with various Market Timing systems. His ultimate strategy came in the follow up book Beating the Dow with Bonds where he combined the Dogs of the Dow with Market Timing based on Valuation.


How it works ?

The strategy invests in Stocks when valuations are compelling relative to Bonds. It is one of the simplest Market Timing system to implement as you just need to check it once a year.
  • At the start of the year, check the S&P500 Earning Yield (reverse of PE or 1/PE) and compare it with the 10 years Government Bond.

  • If S&P500 Earning Yield is greater than the 10 Years Government Bond plus a margin (0.3%), then Stock's valuations are compelling compared to Bonds. Invest in Stocks: use the Dogs Of the Dow strategy.

  • If S&P500 Earning Yield is lower than the 10 Years Government Bond plus a margin (0.3%), then Stock's valuations are not compelling compared to Bonds. Invest in Bonds.

  • If you Invest in Bonds, check the price of Gold versus 1 year ago:

    • If Gold price increased versus 1 year ago, then invest in Short Term Bonds: use 1 year Treasury Bills.

    • If Gold price decreased versus 1 year ago, then invest in Long Term Bonds: use 30 years Bonds (preferably Zero Coupon)


Example: S&P500 PE= 23, 10 Years Government Yield = 4.4%, Price Of Gold increased 15% versus 1 year ago.
  1. Compute S&P500 1/PE =1/23=4.35% (a)
  2. Compute Government Yield plus 0.3% margin: 4.4%+0.3%=4.7% (b)
  3. Compare (a) & (b): 4.35% < 4.7%. Stocks PE is too high therefore invest in Bonds.
  4. Gold increased versus 1 year ago so invest in 1 year Treasury Bills and hold for 1 year
  5. Re-start the process at the beginning of next year

Performances

Michael O'Higgins backtested the strategy from 1972 to 1998 (The Complete Idiot's guide to Market Timing provides 2 more years till 2000) so include both bull and bear markets. The strategy provided an annualized return of 23.1% against the Dow's 9% over the same period.

Now, a few points to ponder:

  • The spectacular gains came from investing in Zero Coupon Bonds from 1981 when interest rates started to drop. Beating the Dow with Bonds was out of stocks in the secular Bull Market of 80s and 90s. The strategy may lack robustness in a rising interest rates environment. Do not expect the strategy to outperform by the same margin in the coming many years.


  • A drawback of the strategy is that it is not easy to invest in Zero Coupon Bonds.


  • When the strategy invest in 1 year Treasury Bills, it almost always underperforms the Dogs of the Dow
    • . You may very well adapt the strategy and stick to Stocks when it asks you to invest in 1 year Treasury Bills.

    Beating the Dow with Bonds can be adapted to any Value Investing

    Instead of using the Dogs Of the Dow when the system tells you to invest in stocks, you can use any Value Investing strategy: for instance, these highlighted by James O'Shaughnessy in What Works On Wall Street or build your own Value Investing.

    In fact, many value strategies are highly correlated, so substituting one strategy to another in a Market Timing system will work.

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