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When Robert Shiller won the Nobel Prize in Economics in 2013, I was mainly familiar with his work through books he had written. But after he won the award, I began digging into his papers.
It's surprising how much tradable information is in the old papers of Nobel Prize winners.
In 1987, Shiller published "Fashions, Fads and Bubbles in Financial Markets," a paper that explained how fashions and fads explain price movements in the markets. Shiller deliberately chose the idea of fashion because, as we all know, fashions change. The same idea applies to the stock market, both in the sense that investor preferences change over time, as well as how fashions and fads drive sector rotation in the stock market.
Fashions and fads also drive the short-term performance of systems. Some years, a system will beat the market; other years, the system will lag the market as the fashion changes. But, over time, fashions like "value" deliver results for patient investors who ignore short-term results and focus on the long term.
In 2017, my twist on the "Dogs of the Dow" strategy underperformed the market, gaining just 1.4% when the S&P 500 was up more than 20%. Some investors might be tempted to look for the new fashion in 2018 but that could be a mistake. Over the five years I have been sharing these trades with you, they have delivered an average return of 73.6% -- more than five times better than the Dow Jones Industrial Average.
For those of you who aren't familiar with this popular trading strategy, here's how the "Dogs of the Dow" works: Every year, you buy the 10 highest-yielding stocks in the Dow Jones Industrial Average, which is comprised of 30 of the largest -- and arguably safest -- companies in the world. Then, at the end of the year, you sell the old "Dogs," and repeat the whole process over again.
The idea is that the higher yields indicate better value... and, therefore, the chance for above-average returns. And the strategy does appear to deliver on that. Between 1973 and 1996, the year this strategy was first published, the Dogs returned an average of 20.9% annually versus 15.8% for the Dow.
And while some strategies stop working as soon as they are published, that hasn't been true for the Dogs of the Dow. From 2000 through the end of last year, the Dogs have gained an average of 8.6% a year while the Dow is up an average of 6.9% a year.
There's also a popular variation of the strategy called the Small Dogs of the Dow, which involves buying the five lowest-priced Dogs. This strategy also has a lot of bite to its bark, beating the traditional Dogs in the past one-, three-, five-, 10- and 20-year periods.
My twist is that, rather than use actual shares of those companies for the strategy, I use long-term call options. (Just like the original strategy, I also sell these call options on the last trading day of the year, even though there's still more time till expiration.)
Last year, I recommended calls expiring in January 2018, which gave us exposure to the stocks for one year. To minimize trading costs, I chose calls with strike prices near the stock's current market price. The table below shows the results when the positions were closed on Dec. 29 (the last trading day of 2017):
Simply buying and holding these five stocks over the same period would have resulted in a gain of about 9.5%, including dividends.
My strategy -- as well as the actual Small Dogs of the Dow strategy -- underperformed this year. However, they both underperformed by such a wide margin that it makes sense to give it one more year, to see if the market's fashion changes.
This year, the 2018 Small Dogs of the Dow and their corresponding call options (scheduled to expire Jan. 18, 2019) are:
Buying these five call option contracts would cost about $1,527 (each contract controls 100 shares of the underlying stock, so we multiply the cost by 100). Because these five option contracts would cost much less than buying 100 shares of each of the stocks outright, traders can commit a smaller amount of their capital to this strategy.
The trading capital saved by using call options could be invested in another strategy, providing diversification and the opportunity for additional gains.
The risk is limited to the price paid for the options. If we get a significant correction or even enter a bear market in 2018, investors following a simple buy-and-hold strategy with the Dogs of the Dow stocks could lose much more than that in dollar terms.
If you're interested in using options to change your financial future in 2018, one of my colleagues has put together a free report detailing how he uses simple call and put options to earn five to 10 times as much per trade as average investors. He's essentially raiding the market... walking away with 80% while other investors are making 8%. You can access his report for free here.
As I'm sure you are all aware, stock prices have been unusually volatile lately...