It’s No Different This Time

July 6, 2011

The Leuthold Group’s July Green Book takes an updated look at the 20-year trailing stock/bond differential:

As we’ve noted before, when ten-year Treasuries outperform stocks over long periods of time, it is a pretty rare condition deserving of attention. Historically, when this occurs it has been a pretty good time to buy stocks.

(Click to enlarge)

Since 1926, the stock/bond performance differential has fallen to negative on three occasions. In 1933, the differential dipped negative and stocks went on to deliver a +34% total return ACR over the next five years. However, ten-year Treasuries lagged substantially, turning in a much lower +4.6% ACR. The differential fell negative a second time in 1949. As before, stocks subsequently went on to deliver sharply higher returns in the ensuing 5-year period. The total return ACR in this five year period was +23% for stocks, compared to a meager +1.6% ACR from ten-year Treasuries.

It’s no different this time. Although five years have not elapsed since the differential plunged to a 62-year low, stocks have handily outperformed ten-year Treasuries in the nine quarters since then. Since Q1-2009’s low, the S&P 500 has turned in a +27.7% annual compound total return, while ten-year Treasuries have delivered a 1.4% total return gain on an ACR basis. It appears history is repeating itself once again.

Published with permission from The Leuthold Group.

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Swimming Naked

July 6, 2011

Matthew Tuttle has an entertaining article in Advisor Perspectives on momentum. And he definitely has some skill in turning a phrase! For example, when discussing the tension between Modern Portfolio Theory and Tactical Asset Allocation, he writes:

In 2002 and 2008 the investment tide went out. And as Warren Buffett famously predicted, we learned who was swimming naked. Both times, it was the practitioners of Modern Portfolio Theory (MPT).

He also has an interesting theory on why relative strength (momentum to academics) is so little used—or at least admitted to—on Wall Street:

Momentum is the documented tendency of investments to persist in their performance. Stock and bond sectors that outperformed other sectors during a period of time (one month, three months, six months, etc.) tend to continue to outperform. More than 300 academic papers have been published showing that momentum outperformance exists in just about every asset class.

If momentum is such a great strategy, then why aren’t more people using it? Think back a few hundred years, when it was official church doctrine that the Sun and planets orbited around the Earth. That was not considered theory — it was taught as fact. Any other idea, no matter how well supported, was heresy. That is the state of the financial services industry today. It has so much invested in the idea of MPT that if it were proven that it didn’t work, such evidence would be devastating.

He also discusses why MPT appears to work much of the time, but finds these arguments ultimately unconvincing:

The years 2002 and 2008 were not flukes. It is human nature to create bubbles in asset classes that eventually burst. Human beings are ruled by emotions. Greed and ignorance cause bubbles to form, and fear causes them to burst. Until we all become Vulcans, bubbles will continue to form and burst. (Unless you believe that the government can head off bubbles in the future. If you do, I have a bridge in Brooklyn to sell you.)

For Sale to Modern Portfolio Theorists

Source: www.answers.com

Whether you decide to buy the bridge or not, it is clear that MPT has some problems. Behavioral finance addresses some of these shortcomings, but has been criticized as having no unifying theory of its own.

Here’s my version of a unifying theory: both relative strength and deep value work because they are non-consensus and thus inherently psychologically uncomfortable. They continue to work because people refuse to take advantage of the excess returns available-it’s just too uncomfortable when you are temporarily out of synch with the market. Both anomalies are well-documented but—in contrast to what theory says should happen—so far the excess returns have not been arbitraged away. Unless human nature changes, that situation is unlikely to change.

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What’s Hot…and Not

July 6, 2011

How different investments have done over the past 12 months, 6 months, and month.

1PowerShares DB Gold, 2iShares MSCI Emerging Markets ETF, 3iShares DJ U.S. Real Estate Index, 4iShares S&P Europe 350 Index, 5Green Haven Continuous Commodity Index, 6iBoxx High Yield Corporate Bond Fund, 7JP Morgan Emerging Markets Bond Fund, 8PowerShares DB US Dollar Index, 9iBoxx Investment Grade Corporate Bond Fund, 10PowerShares DB Oil, 11iShares Barclays 20+ Year Treasury Bond

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From the Archives: Every Big Idea That Works

July 6, 2011

“Every big idea that works is marked by simplicity, by clarity. You can understand it when you hear it, and you can explain it to people.” —Peggy Noonan, Wall Street Journal

Relative strength investing is just such an idea that works, is marked by clarity, and can be easily explained.

Most investors find investing to be incredibly complex. For an experiment, ask 10 investors what makes a stock go up or down and observe the disparity in responses. Some may say that it is the earnings of the company that determine the stock price. Other responses may focus on the perceived value of the company, a good story of the company’s prospects, market psychology, the overall health of the economy, availability and cost of money, fads, pronouncements of the President or Chairman of the Fed, analyst ratings, share buybacks, dividends, mergers and acquisitions, or speculation of the price itself.

Without minimizing the influence of any of these factors, a technician looks at the bigger picture to conclude that stock prices change every day and over time because of all of these reasons and more. In any given period, buyers and sellers of securities will be influenced more by some factors than others. The culmination of all of the factors influencing the buying and selling decisions of investors tends to cause prices to move in trends– often multi-year trends. Relative strength simply provides a framework for ranking securities by the strength of those trends and investing in the strongest of those trends.

—-this article was originally published August 24, 2009.

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