Is It Time For A Defensive Equity Strategy?

Includes: PHYS
by: Steve Shea


The S&P 500 and the Dow 30 have had an amazing run during the last decade.

Charts are analyzed to explore possible outcomes.

A unique approach is presented that might preserve profits in the event of a market decline.

The Dow 30 closed at $26,616 on Jan. 26 this year. On March 23, it closed at 23,533. At that level, the Dow was down 5.7% for the week, and 11.6% from its all-time high. As of this writing (March 30), the Dow has recovered $570, or 2.4%. There has been much speculation about where equities are headed. If the bears are correct, where should the money be invested, if not in stocks? What if the bears are wrong? This article attempts to use history to provide possible answers to these questions.

If a portfolio has been invested in stocks for the past decade, it has probably doubled, and possibly tripled in that time frame. A debacle such as the 2008 stock crash could cut those profits in half. Here is a 22-year graph of the Dow Industrials:

This is a logarithmic graph that shows percentage gains rather than point gains or losses. Notice the drop in 2008 was about 50% from high to low. The recent drop that was referenced in the lead paragraph, while over 3,000 points, is only an 11% drop, so it is small on this graph. The 2008 drop was "only" around 7,000 points, but the high reached in 2007 was 14,000 points. So the 2008 crash represents a 50% drop, thus a much longer decline than the current one. Today, the Dow would have to drop to 12,000 points to display a trend line that long. I have also included the 50-day and 200-day moving averages on this graph. The 200-day average is in dark purple, while the 50-day average is a lighter color. Some chartists sound alarms when the 50-day average crosses above or below the 200-day average. Others watch when the Dow average crosses above or below these thresholds.

The Dow would have to fall 20% for the 50-day average to cross below the 200-day average, so the crossing of these averages hardly seems like a leading indicator. The Dow average hasn’t crossed below the 200-day average since 2011. However, it has dropped below the 50-day average a few times, and is close to closing below that average at this time. The Dow doesn’t need to fall much further to cross the 50-day average. It hasn’t happened in the past year, and when it happened in 2015 and 2016, the drops were not severe. However, it was a great indicator of the 2001 and 2008 declines. That indicator only highlighted half of the decline in 1998. Based on today’s chart, selling when the Dow breeches that 50-day average would preserve much of the gains realized this past decade, if an investor were to heed it and the market were to fall much farther.

I am not forecasting impending doom for the market partly because my forecasting skills are severely limited and flawed. But bear in mind, I exercise caution being that I am currently retired. I have developed a strategy that I have modeled over the past 30 years, which has included 3 bear markets. This strategy is defensive and preserves capital. The average 10-year returns for my strategy yielded 8.5% per year vs. 11% for the Dow 30. However, the worst decade performance was a positive 6.4% annual return compared with the worst decade for the Dow 30 that yielded just 1.3% per year. The best 10-year performance was 12.3%, which is much lower than the best 10-year performance of a similar investment in the Dow 30. The Dow returned a spectacular 18.2% in the decade from 1989 to 1998. All Dow 30 returns assume that dividends are reinvested. I am willing to limit my potential gains and lock in current profits, if downside losses are averted. This strategy appears to do just that, if history is a guide.

The investment philosophy I show here is to split the investment equally between gold and the Dow 30. At the end of every year, the investment is reallocated so that the split remains half in gold, and half in the Dow 30. Dividends are reinvested. I have included a chart that shows the raw data. The chart assumes that the investment at the start of the decade is $10,000. The numbers in green are the absolute best decade; the numbers in red are the absolute worst return. The numbers in italics highlight the investment that had the best return during that decade. Although some of the Dow returns were amazing during the 1990s, the combination of gold and the Dow yielded better returns than the Dow in many of the past decades.

This chart shows what happens when $10,000 is invested at the start of each decade and rebalanced equally between gold and the Dow 30 average at the start of each successive year.

I chose gold and the Dow 30 because neither investment will ever go to zero, nor do they require individual stock picking skills. My data shows there is absolutely no correlation between those two asset classes. Sometimes those two investments increase during the same spans, sometimes they vary inversely. Here is a graph of those two investments during the past 15 years. The yellow line is gold, and the blue line is the Dow 30. This graph was obtained using Yahoo Finance, so the Dow 30 doesn’t reinvest dividends. If it did, the Dow investment would have exceeded gold over this span. But it does show that there is little correlation between the two investments.

There are many benefits to this strategy. One strong benefit is preservation of capital. The worst performance in any decade was a 6% per year appreciation. If any stock in the Dow 30 becomes suspect, it will be replaced by the index by a high quality company. Gold has intrinsic value. Rebalancing the assets each year means that some profit is being claimed each year and reinvested elsewhere. A portion of the portfolio is being sold at a higher price and reinvested in an asset at a lower price. With a buy and hold philosophy, profits are never locked in and are subject to market risk.

No investment strategy is perfect, and there are flaws to this one. When the portfolio is rebalanced, that can be a taxable event, and those taxes must be paid. Gold appears to be over-weighed in this strategy. However, I modeled a portfolio with a 20% exposure to gold (80% to the Dow 30) and found that the worst and average performances were worse than the 50/50 split over the past 30 years. Gold has neither earnings nor dividends. A portfolio entirely in dividend-paying stocks would yield a dividend each quarter, even with a buy and hold investor. Ultimately, gold is a rock, or coin or bar or jewelry sitting in a safe somewhere. It is a store of value and as such often behaves much like a foreign currency.

Let’s look at the big picture. Stocks have been essentially rising for the past 9 years, while commodities are at multiyear lows. The stock market usually rises in years that the 10-year treasury rates were below 3%. Rates may rise above 3% this year. Oil prices have been steadily rising for the past 3 years. While this might be good news for the oil industry, it affects the price of all finished goods as well as commodities. As energy costs rise, the cost to produce an ounce of gold also rises. Finally, with the increase in government spending, there will be more dollars available, which is also inflationary. The United States can produce dollars, but it cannot guarantee the purchasing value of its currency.

The Consumer Price Index has been below 3% for the past 6 years. Although inflation has not been a problem yet this century, it is a very real concern against a backdrop of rising interest rates, energy costs, and dollars in circulation. I think inflation will be a major investment challenge over the next decade. The fact that gold is a hard asset and exists independent of these inflationary factors is the very reason why it is an important asset class to own.

There are a few ways to invest in gold.

  • The obvious way is to own gold coins and store them in a safe place. For investment, I would only buy bullion coins that do not carry a large premium to spot price. Coins are not to be used for short-term investing, as the spread between buying and selling can be 10% or more.
  • There are some investment vehicles that match the price of Gold. SPDR Gold Shares (GLD) is the largest one, and if you read the prospectus, it uses a combination of gold and paper products (like options) to attempt to match the price of gold. Historically, it has closely followed the price of gold since its inception in 2004. There is a much better alternative, in my opinion. The Sprott Physical Gold Trust (NYSEARCA:PHYS) invests in gold bars, which are audited and stored in vaults. The main reason to invest in gold is that it is a hard asset. GLD is not backed 100% by gold. PHYS is guaranteed to be 100% backed by gold. Make sure to check the net asset value of the fund prior to investing. At the current time, PHYS is selling at a 0.74% discount to the value of gold in the Sprott trust, which is close to its historical lows.
  • The third way to invest in gold is to buy gold mining stocks. Most gold miners are extremely speculative and I would not recommend them in a retirement portfolio. Because of the risk, these stocks may perform 2 to 3 times the spot price of gold, in either direction. Here are some of the potential pitfalls:
    • Flooding can occur or mines can collapse
    • Geopolitical risks are always possible
    • Governments can nationalize the mines
    • Labor problems
    • Energy related expenses
    • Management sells more shares, diluting the value of current shares
    • And many more

In summary, a mix of quality stocks and gold is a great way to diversify a portfolio. It provides safety and reasonable appreciation if past history is used as a guide. This strategy can easily be started, and does not consume much time, energy, or investment knowledge to maintain. I am exercising caution in my own investments, while trying to eke out reasonable returns.

These are my thoughts alone, and do not constitute investment advice. Your individual strategies may vary depending on tax consequences, your personal mix of assets and other considerations. Although my data spans 30 years, there are no guarantees that future performance will be anything like the data shown in these charts. Comments are always welcome.

Disclosure: I am/we are long PHYS.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.