Systematic Relative Strength

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A very interesting article by Randall Forsyth in Barron’s discusses the problem conservative investors are having right now. Economists are worried about inflation down the road if the government chooses to monetize its debt. But the current problem for investors is deflation.

Deflation has driven interest rates on cash to near zero. Interest income is $50 billion lower than a year ago. The recession has caused corporations—many of them financials—to cut dividends as well. I was surprised to learn that overall dividend income is down 25% from a year ago. And it is projected to get worse.

This can’t have a positive effect on consumer spending. And when consumer incomes drop, tax revenues also drop, which puts more pressure on the national deficit.

Investors are also in a bind. The best yields are available, as always, on the riskiest paper. Most of the time, if CDs and Treasurys have reasonable yields, the “widows and orphans” investors ignore high-yield debt. But under the current circumstances, I suppose there is a risk of investors stretching out their risk parameters to reach for yield. Given that bond mutual fund sales have recently been running at five times the level of stock fund sales, I’ve got to wonder whether all of that cash is ending up in an appropriate place on the risk spectrum.

The faster the economy of a country grows, the better it is for that country’s stock market, right? Uh, not exactly. Click here to read the Economist’s summary of the work done by Elroy Dimson, Paul Marsh and Mike Staunton at the London Business School back in 2005. Over the 17 countries they studied, going back to 1900, there was actually a negative correlation between investment returns and growth in GDP per capita.

Emerging markets are doing great right now and that trend may persist for years. However, it would be incomplete to conclude that they are doing so solely because of growth in GDP. Supply and demand determine all prices. Prices trend. Investors who follow those trends in a systematic way can generate superior investment results over time. It is not necessary to get more complicated than that.