Systematic Relative Strength

Ed Yardeni may be Wall Street’s favorite economist/investment strategist, not least because he always has great graphics. The smart commentary is just a bonus! Recently, he wrote how he was expecting S&P; 500 earnings to decelerate based on the recent weakness in ISM’s Purchasing Manager’s Index. As always, he had a nifty graphic to show the relationship:

Source: yardeni.com (click on chart to enlarge)

When earnings growth slows, it often highlights the growth monsters—companies with extremely powerful growth drivers that continue to generate earnings when everyone else decelerates. Growth monsters are always around, but during a cyclical rebound it is not always easy to distinguish them from companies that temporarily have the wind at their back. Growth monsters are more apparent when everyone else is slowing down.

Relative strength tends to identify growth monsters very effectively. Below is a table of the top performing stocks in the S&P; 500 and the S&P; Midcap 400 for the trailing 12 months. All of the companies that I highlighted in the table are owned in the Technical Leaders Index (PDP) or in one of our Systematic RS separate account styles. We’re never going to get everything, but you can see that the methodology finds a lot of the dynamic performers in the market.

Source: Dorsey, Wright Money Management

Disclosure: A list of all holdings for the past 12 months is available on request.

The Economist has a modest article that eloquently makes a really, really important point.

• Buy and hold is a crock

Indeed, they point out that in lots of markets you never know if equity returns are going to exceed bond returns.

…as Deutsche Bank’s long-term asset study (the subject of yesterday’s post) makes clear, this has not been true for all markets. Over the last 50 years, the real returns from equities have been lower than those from bonds in Germany, Japan and Italy. In the Italian case, the gap is almost three percentage points, and that is despite the recent bond sell-off (actually, as Deutsche points out, a 5-6% yield on Italian debt is quite low by historical standards.)

Why, then, is buy-and-hold taken as such an article of faith by many naive investors? The Economist makes it clear that it is simply an accident of history.

The buy and hold mantra was developed in the US where real equity returns have generally been positive over long periods. But the US was history’s winner in the 20th century; enjoying 100 years of political stability while its European rivals destroyed themselves in two world wars and Russia followed the dead end path of communism. The US equity market, in other words, displays distinct survivorship bias.

We’ve written many times about the Japanese equity experience of the last 20 years as an example that markets don’t have to go up, even over the very long run. Markets don’t guarantee you anything except a chance to compete for returns.

Most important of all, The Economist piece has a very sage piece of advice—maybe one of the most important things for an investor to keep in mind.

There is nothing so catastrophic for an asset class as the conviction that its price can only go up.

In other words, it’s not different this time.

Hat tip to Abnormal Returns, a must-read blog.