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Relative Strength Investing Trends: Fixed Income Considerations with Jamie West, CFA

Relative Strength Investing Trends: Fixed Income Considerations with Jamie West, CFA

This month, we gauge the environment for relative strength investing in this unique market as well as highlight an insightful Q&A with Senior Analyst, Jamie West, CFA on all things fixed income.

What’s Hot…and Not

How different investments have done over the past 12 months, 6 months, and 1 month. Never before has it been easier for investors to invest in the strongest trends wherever they might be found in the world. Relative strength offers a disciplined framework for allocating among those trends. Markets are global and your portfolio should be too. As of 4/20/20:

April 2020 Relative Strength Investing Trends

Past performance is not indicative of future results.

See disclosures in Appendix A, which includes the ETFs and Indexes used for this performance table. Performance numbers include dividends but do not include all transaction costs. Investors cannot invest directly in an index. Indexes have no fees. Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss.

Fund Flows

Total estimated inflows to long-term mutual funds and net exchange traded fund (ETF) issuance collected by The Investment Company Institute.

April 2020 Relative Strength Investing Trends Chart 2

See disclosures in Appendix A.

Sector and Capitalization Performance

April 2020 Relative Strength Investing Trends Chart 3

Past performance is not indicative of future results.

See disclosures in Appendix A.

High RS Diffusion Index

As of 4/20/20:

April 2020 Relative Strength Investing Trends Chart 4

The 10-day moving average of this index is 31% and the one-day reading is 43%. This index has rebounded over the last couple of weeks after hitting a one-day low of 1% on March 23. Pullbacks in this index have often provided good opportunities to put new money to work in the markets.

See disclosures in Appendix A.

Relative Strength Spread

The chart below is the spread between the relative strength leaders and relative strength laggards (universe of mid and large cap stocks). When the chart is rising, relative strength leaders are performing better than relative strength laggards. As of 4/20/20:

April 2020 Relative Strength Investing Trends Chart 5

RS leaders have been performing better than the RS laggards for the better part of 2020 as reflected in the rising RS Spread. 

See disclosures in Appendix A. 

Fixed Income Considerations with Jamie West, CFA

I enlisted Jamie West, CFA, Senior Analyst at Nasdaq Dorsey Wright, to share his views on the fixed income markets in the following Q&A, which I believe that you will find insightful.

Q: Can you tell us a little about your background?

A: I grew up in Richmond, VA, where I still live. I attended the University of Mary Washington as an undergraduate and Tulane University for grad school. Prior to joining Nasdaq Dorsey Wright I worked for a firm that ran investment pools for local governments which included a pension-like fund which was invested across all asset classes and also high-quality short-term fixed income funds in which municipalities could invest their general fund balances.

Q: What do you see as the primary role of fixed income in a client’s asset allocation?  Is there anything about that view that has changed over time?

A: Despite the recent volatility in the bond market, I believe that the fixed income sleeve of a portfolio continues to be viewed as the “safe” part of the portfolio. Advisors with clients who require a steady stream of income from their portfolios, have traditionally relied on fixed income to generate a large portion of that income. However, over the last decade yields have fallen fairly consistently and as a result many investors have had to take on additional risk to meet their income needs. The exact form that risk takes varies, some investors have taken on credit risk by allocating more to high yield, taken on additional duration, or increased their equity exposure by investing more in high dividend stocks. The net effect is that most portfolios and fixed income allocations have gotten riskier and may also be producing less income at the same time. Unfortunately, the people taking on this risk are typically older clients who, all else equal, are least able to bear it.

Q: As you look back at how different bond classes have performed so far in 2020, is there anything that has surprised you?

A: At the beginning of the year, I don’t think many people would have guessed that Treasury yields would be at their current levels. Prior to this year, the lowest yield ever on the 10-year US Treasury was around 1.45%. Currently, the 10-year is yielding around 62 basis points or less than half of the lowest level it reached prior to 2020. And because of falling yields, long-duration Treasuries have been amongst the best performers this year, which of course comes directly after 2019, which was also very good for long-duration. I think many of us were also surprised by how sharply investment grade credit spreads increased in March.

Q: Can you tell us about the construction of the U.S. Aggregate Bond Index?  What are some important characteristics of this index that you think are not as widely understood as they should be?

A: The US Agg index is constructed of primarily of intermediate-term US Treasuries, investment grade corporate bonds, mortgage bonds, and US agency bonds. I think one thing that a lot of people are unaware of are the differences between bond indexes and the equity indexes they may be more familiar with. Fixed income indexes are evaluated more frequently, have higher level of turnover, sometimes 10x or more, and can have pretty drastic changes in their exposure and risk level. Over the last 10 years companies have borrowed for longer to lock in lower rates, and coupon payments have fallen, both of which have contributed to increased duration, so owners of products that track the Agg are now receiving less income and have more risk.

Also, as with equity indices, many fixed income indices are essentially market-cap-weighted. In equity indices, market cap weighting means that the most historically successful companies (at least in terms of increasing their market value) become the most heavily weighted. In a market cap weighted fixed income index, the most heavily weighted entities are those that have issued the most debt. This presents a problem for the buyer of a cap weighted fixed income index, as they will be most heavily exposed to the most debt-laden and not necessarily the most creditworthy of issuers.

Q: What are some advantages and disadvantages of creating a bond ladder?

A: One of the major advantages of creating a bond ladders is that, as long as the yield curve remains upward sloping, i.e. bonds with longer maturities have higher yields, the average yield of your ladder increases over time. For example, say you’re creating a five-year ladder. In year one, the first “rung” of your ladder is made up of bonds that you purchased when they had one year left until maturity, which normally have a lower yield than the bonds in the fifth rung of your ladder, which have five years until maturity. By the fifth year, however, your entire ladder is made up of bonds that you purchased when they had five years until maturity and therefore, all else will being equal, the portfolio will have a higher yield than when the ladder was created.

The major caveat of bond ladders is that everything is held to maturity, so you won’t have any capital appreciation, however, you also won’t have any capital losses as long as there are no defaults in your portfolio. If you’re seeking a stable stream of income this isn’t a disadvantage, but, it is an aspect of bond ladders you should be aware of.

Q: Can you summarize some of the most bullish arguments out there for different bond classes in the coming years as well as some of the most bearish arguments?

A: Well, credit spreads, especially high yield spreads, are currently elevated, so, as things improve and economic activity resumes, there is plenty of room for these spreads to narrow, which has the same effect as falling interest rates – it drives up bond prices. So that could be a tailwind for owners of credit bonds. On the other side, front month oil prices went negative, which could have some pretty disastrous results for energy producers and by extension investors who own their debt. Spreads on energy sector bonds had already widened significantly, but there’s certainly the possibility that we could see a wave of defaults from the sector. And of course, Treasury yields are near all-time lows, so as the economy recovers there is a distinct possibility, we could go through a sustained period of rising interest rates, which would be a headwind for many segments of the fixed income market.

Q: Are there any types of passive or active approaches to fixed income exposure that you think may be complementary to a tactical approach to fixed income over time?

A: Tactical fixed income strategies try to identify areas of strength in the market and allocate towards them, so by their nature they tend to be less predictable than static allocations. They generally also aren’t concerned with whether they generate returns via income or via capital appreciation. Therefore, if you want to add some stability or you need to generate a steady stream of income, you might want to consider adding a bond ladder using target-maturity funds like the BulletShares or iBonds ETFs. Obviously, the argument in favor of using a tactical fixed income strategy is flexibility and ability to seek return from both income and capital appreciation, which I believe will be important in the years ahead. 

This communication does not purport to be complete description of the securities or commodities, markets or developments to which reference is made. In all securities trading there is a potential for loss as well as profit. It should not be assumed that recommendations made in the future will be profitable or will equal previous performance. Investors should have long-term financial objectives. Past performance, hypothetical or actual, does not guarantee future results. It should not be assumed that recommendations made in the future will be profitable or will equal the performance as shown. Advice from a financial professional is strongly advised.

Other Relative Strength Sources

  • Brush, John S. "Eight Relative Strength Models Compared." Journal of Portfolio Management (1986).
  • Berger, Israel, Moskowitz. "The Case for Momentum Investing." AQR Capital Management. 2009.
  • Jegadeesh and Titman. "Returns to Buying Winners and Selling Losers." Journal of Finance (1993).
  • O'Shaughnessy, James P. What Works on Wall Street. McGraw Hill, 1997.

Other Topics

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Nasdaq Dorsey Wright

Nasdaq

Nasdaq Dorsey Wright is a registered investment advisory firm with more than 30 years of expertise is technical analysis, specifically focusing on the steadfast relationship between supply and demand in the markets. Our research and tools help our clients see through the day-to-day clutter of market movements while providing a clear understanding of where market strength lies at all times.

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MarketInsite

Nasdaq

Nasdaq’s Marketinsite offers actionable insights on a variety of market-moving topics. Learn from our thought leaders who are driving the capital markets of tomorrow.

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