James O’Shaughnessy’s What Works on Wall Street details one of the most extensive studies of stock returns and stock-picking strategies ever performed. Now, as we approach the second year of what appears to be a bonafide bull market, O’Shaughnessy’s firm has new data on what works during different stages of bull markets.
In a piece written for O’Shaughnessy Asset Management’s website, Patrick O’Shaughnessy says that OSAM’s research has found significant trends in the types of stocks that perform well during and after bear markets, particularly severe bears like the one we’ve just seen. “While the particulars of each bear market are very different, the types of stocks that perform well at various stages surrounding the declines are somewhat consistent around all bear markets and quite consistent around severe bear markets,” he writes. “If history rhymes yet again, these lessons should prove valuable over the next several years.”
In the first year following severe bear markets, O’Shaughnessy writes, low-momentum stocks crush high-momentum stocks — just as we’ve seen in the junk rally that started last March. “During the nearly nine months since the March 9th market bottom, market trends have closely mirrored those of other severe bear markets,” O’Shaughnessy says, adding that the underperformance of momentum strategies suggests not that such approaches are broken, but that “this year has just been more of the same.”
Particularly relevant given we are approaching the second year of the market rally is OSAM’s research into what happens in the second year of bull runs.
According to O’Shaughnessy, bull markets’ second years tend to demonstrate characteristics more consistent with long-term stock movements. Stocks that have qualities like high book/price ratios, high six-month momentum, and high shareholder yield all outperform. “The bizarre market dynamics from the first year of recovery subside in year two and the expected long-term advantage of buying stocks with our [fundamental] criteria returns,” O’Shaughnessy says.
What tends to happen in the third year of a recovery? Broader market returns come way down, and the market is “much friendlier to trend-following and high-yield strategies than to value,” O’Shaughnessy writes. “Momentum, dividend yield and shareholder yield have shown very strong performance relative to the market, while companies with ihgh book-to-price begin to lag considerably.”
O’Shaughnessy says the bottom line is that things aren’t “different this time”, as many have contended. “This market has followed patterns very similar to past severe bear markets, both during the decline and during the recovery to this point.”