This is a question that has frustrated my mind for at least five years. I will give a brief description of value investing before giving a more detailed discussion of momentum.
Value Investing: Invest in a company that has strong fundamentals (strong balance sheet, very manageable debt, positive earning, etc.) but has had its market valuation hit (i.e. trading at an EBIT/TEV at half of the industry average, P/E ratio has been cut in half, etc.). Even though it is a simple concept, it is easy to land in pitfalls. One pitfall is to invest in a company, or asset class, just because it has dropped significantly in value. The saying, “Invest once something goes down” is abused. You still need to put forth some analytical work and understand WHY there is a drop in the valuation or price. Or else you are investing blindly. Look at commodities. Over the last ten years, and last five years, most commodity funds have negative performance, or best case are flat.
Now for momentum investing. The premise for momentum is that a stock, or an asset class, tends to stay overvalued or undervalued longer than one would believe is rational. This raises the question, how much (if at all) does the behavior of investors factor into performance. This leads to the bigger question, are markets efficient? Hence, my struggle over the years with momentum. My short answer to that question is – Yes, markets are efficient…over the long term. However, in any given day, week, month, or even year, there can (and have been) inefficiencies.
Back to momentum.
There are several ways to calculate, or display, the “momentum” factor.
- Fama/French utilize the returns over the prior two to twelve months to find the “momentum” stocks. What is up versus what is down.
- Ben Carlson describes relative momentum and absolute momentum. The former compares an investment against another investment. Whichever one has the stronger performance over a specific time, usually twelve months or less, is the investment to choose. The latter compares an investment against itself, also over a specific time interval, to see if it is outperforming cash. If not, then invest in cash.
- Perhaps the more well-known rule is trending performance. Wesley Gray does a good job researching this rule. Here, you compare the current price of an investment versus the average price over a specific time-frame of that investment. If the current price is greater, then invest. If not, go to an alternative investment. Instead of using a current price, people use the 50 day moving average versus the 200 day moving average.
You can spice up your strategy (though try to keep it simple since simplicity trumps complexity) by combining different elements of the momentum rules. For example, use a trending performance rule together with the relative momentum rule. Steve Blumenthal displays the use of three asset classes to outperform the S&P 500.
You may think, “Okay, this is great!” However, just like any rules-based strategy, the most difficult part is following the rule 100% of the time. It can be a psychological strain for an investor to move all of his/her assets from stocks to bonds to cash. And just like all strategies, no strategy outperforms its rivals 100% of the time. There can be lagging performance for years. YEARS! And what has worked in the past may not work in the future.
Another caveat is that the momentum strategy will be applied incorrectly. If you notice, the above links show research/data on the momentum strategy either using thousands of stocks (i.e. Fama/French) or entire asset classes. In my opinion, it would be very dangerous for an investor to read about momentum, and then try to implement on his/her own. Below is my fear.
- Investor reads about momentum.
- Analyzes the presented data.
- Likes the out-performance.
- Applies momentum rule to portfolio.
- Portfolio consists of 20 stocks.
- Portfolio drastically under-performs S&P 500.
- Investor gives up and sits on cash for five years.
- Investor gets back into market.
- Five months later market turns into a bear market.
- Investor gives up.
A bleak picture for sure. Unfortunately, the above scenario is far too common in the investment world. To prove my point, I chose five stocks and analyzed the data for the last ten years. I applied a simple trending momentum, moving average strategy on those five stocks. It went like this:
- Pulled the last ten years’ worth of data from Yahoofinance.
- Set up a simple 50 Day Moving Average versus 200 Day Moving Average.
- If 50 Day MA > 200 Day MA then invest in stock.
- If not, go to cash.
- Compare the trending momentum performance versus a buy and hold strategy.
- Buy and Hold – Buy 100 shares of stock and do not trade.
The study seems simple enough. In order to keep it simpler, I took out the effect of dividends and transaction costs. The results are alarming for those who want to use momentum rules for their individual stock portfolio.
As you can see for four of the five stocks, a trending momentum strategy drastically UNDER-performed a basic buy and hold strategy. Now, there could be reasons for this under-performance.
- I chose large cap stocks.
- I did not choose a stock from all sectors.
- All stocks had an overall positive return from year one until now.
- Sample size is extremely small relative to the thousands of stocks traded on the exchanges.
My list is by no means exhaustive.
Why the drastic under-performance? I believe it is due to the sudden price drops, or rises, that occur when one invests in individual stocks. If a stock drops by ten to twenty percent over a few days, there is not enough time for the trending performance to adjust and trigger a sale. Also, the inverse occurs. If a stock rises by ten to twenty percent in a few days, the investor will miss the recovery. One ends up “leap-frogging” back and forth to no avail. Perhaps this shows that too much volatility will break the rule.
I believe momentum strategies can work if applied correctly. My point is for individual investors to heed warning when trying to emulate the performance of these momentum strategies.
As always, this if for informational and educational purposes. Nothing contained herein constitutes tax, legal, insurance or investment advice, or the recommendation of or an offer to sell, or the solicitation of an offer to buy or invest in any investment product, vehicle, service or instrument. What has worked in the past may not work in the future. Past returns do not guarantee future results.