Systematic Relative Strength

Patrick O’Shaughnessy’s recent research confirms that the stock market has historically handsomely rewarded those who step up during troubling economic times (like we are in now). The entire research paper is well worth the read.

The natural emotional response to a weak economy and uncertainty about the future is one of conservatism. The dominant trade in 2010 has been out of stocks and into bonds, or looked at another way, away from risk and into apparent safety. The trouble with this investment decision is that for many it is based on what this research has found to be irrelevant data points. GDP growth, unemployment, taxes, and consumer sentiment all seem like they should matter for your portfolio, but 110 years of history says that they do not. The relationships between these sensitive economic variables and future equity returns are very weak and, if anything, contrarian.

The recession is now over. According to the National Bureau of Economic Research, the recession actually ended in June 2009. Oh, wait-wasn’t that more than a year ago? Welcome to the wonderful world of economics, where time travel is possible. But just in case Scotty is not able to beam you back to June of 2009, here is a nice illustration of why the S&P 500 is part of the Index of Leading Economic Indicators.

source: Yahoo! Finance (click to enlarge)

The S&P 500 bottomed in March 2009, three months ahead of when the time-traveling economists have now determined the recession ended. This is just another demonstration of why price matters and why price data is the primary input into our systematic relative strength process.