Systematic Relative Strength

The Leuthold Group’s October Green Book included an interesting update on the stock/bond performance differential. As pointed out in the table below, the stock/bond performance differential hit generational lows as of the end of the first quarter of 2009.

(Click to Enlarge) Chart courtesy of The Leuthold Group

However, we have seen a sharp reversion to the mean since the bottom of the bear market on March 9, 2009, as shown in the chart below.

(Click to Enlarge) Source: Stockcharts.com

The Leuthold Group ran the same stock/bond performance differential analysis at of the end of September 2010 to see how much the strong performance in stocks has impacted the percentile ranks. Interestingly, even with the strong outperformance of stocks over bonds over the last 19 months, the stock/bond performance differential remains in the cellar, as shown in the table below. In fact, the 30-year stock/bond performance differential remains in the bottom percentile!

(Click to Enlarge) Chart courtesy of The Leuthold Group

The Leuthold Group concluded “going forward, we expect the stock/bond performance differential to continue to move in the direction of the median, which implies stock market total return performance will run far ahead of the total return of ten-year treasuries.”

Retail investors are all over this as they are positioning their portfolios to capitalize on this likely reversion to the mean…oh wait, maybe not.

Analysis, such as that shown above, offers the advantage of putting current events in the context of longer-term history. However, we freely acknowledge that it is no guarantee of what is to come. Above all, investors can benefit from maintaining a flexible asset allocation. One of the greatest benefits of using relative strength to drive asset allocations is that it dispassionately identifies strength—and if that strength is in stocks (or bonds, commodities, real estate, currencies…) then so be it.