When it comes to using strategies to guide your investment decisions, the pursuit of price momentum rates among the most successful and the most uncomfortable. Over the years, quant fund managers and academic researchers alike have espoused the virtues of momentum as a means of beating the market. However, since the 2009 market lows, sceptics have begun to question whether the momentum effect even exists any more.
Momentum investing really hit the headlines in 1993 when a seminal paper was published by US academics Jegadeesh and Titman, which showed that stocks that perform the best over a three- to 12-month period tend to continue to perform well over the subsequent three to 12 months. Likewise, the worst performers continue to perform badly. This observation triggered reams of further analysis, which narrowed down the momentum effect as something that specifically occurred between the second and eleventh month after the investment. Either side of that timeframe, the effect either didn’t work or went into reverse.
The general consensus in support of momentum claims the effect can be blamed on several factors, although the jury is still out on what these really are. One of the most popular suggestions is a type of behaviour known as the “disposition effect”, which relates to how both private and institutional investors react to news about a stock. The main point being that investors tend to sell too quickly on good news to lock-in profits while selling too slowly on bad news in the hope of eventually breaking even. In the words of US economist Toby Moskowitz, the effect:
“causes an artificial headwind: when good news is announced, the price of an asset does not immediately rise to its true value because of premature selling or a lack of buying. Similarly, when bad news is announced, the price falls less because investors are reluctant to sell.”
In other words, the disposition effect creates the environment that’s needed for momentum to occur in the subsequent months.
Highs and lows of momentum
One of the idiosyncrasies of momentum investing is that while the approach has been shown to work in bull and bear market conditions, the point at which markets turn can be seriously damaging to the strategy. To put this unnerving risk into context, Tom Hancock at investment firm GMO crunched the numbers in 2010 and found that a 12 month momentum strategy (that excluded the first month) outperformed the market by nearly 4% per year over the period from 1927-2009. That sounds good. But the trouble, as Hancock notes, is that the effects of the market crash in 2008 and 2009 effectively wiped out the momentum gains for the entire first decade of the 2000s. Those market swings can have a dramatic impact.
For Hancock and GMO, whose funds tend to be much more concerned with stock fundamentals, this risk isn’t a major problem if handled carefully. But for others it is: sceptics are now arguing that market efficiency has caught up with momentum and ironed it out altogether. A 2011 paper by Bhattacharya, Kumar and Sonaer found that momentum profits had disappeared since the late 1990s. Among the reasons why this might be, they suggested that hedge funds had arbitraged away these potential gains and that the disposition effect had unwound itself as investors got better clued-in on how they should react to news. Likewise, a 2010 study by M. Scott Wilson, found that a price momentum strategy would have lost you money between 2005 and 2010.
So where does that leave momentum? Well, according to GMO’s Hancock, market conditions in the last five years have shaken out many quant fund managers from this type of trading (where it can be hard to justify to clients why you simply bought stocks that were rising, and then lost money doing it). Indeed, he claims that when momentum has failed in the past and fallen out of favour, is when it has subsequently done the best. As a result, the technique is well placed as a contrarian strategy – and as such, it can still work. Moreover, the components of momentum actually go beyond simply price – earnings momentum, fundamental momentum and technical indicators such as moving average convergence/divergence (MACD) are all involved as well – but more about all that in the next article.
Filed Under: Momentum Investing,