Systematic Relative Strength

Stocks have been disappointing investments this decade. In fact, bonds have outperformed stocks not just for the last ten years, but have had returns that are competitive with stocks for the last 40 years. The way investors are piling into bond funds it is clear they expect this trend to continue.

Mathematically that isn’t very likely. In this article from Private Wealth Management, Roger Ibbotson and Peng Chen decompose the sources of stock and bond returns and suggest what is most likely going forward.

Their conclusion mostly has to do with the starting valuation levels, an argument most of you are probably familiar with when analysts make equity market return forecasts. The higher the initial valuation, the more likely future returns will be disappointing. With the bond market, yield levels substitute for valuations. Starting from the low level of interest rates we have currently, what are the odds of good performance going forward?

The table below shows the performance of a universe of mid and large cap U.S. equities, broken down by relative strength decile and quartile and then compared to the universe return. Those at the top of the ranks are those stocks which have the best intermediate-term relative strength. Relative strength strategies buy securities that have strong intermediate-term relative strength and hold them as long as they remain strong.

Last week’s performance (11/2/09 - 11/6/09) is as follows:

Last week was a great week for high relative strength stocks as the top quartile nearly doubled the return of the bottom quartile and also beat the universe return by a healthy margin.