Momentum as an Investment Style
Over the years there has been a significant amount of academic research conducted on the factors driving stock price movements. Researchers have focused on identifying reasons why stocks with certain characteristics tend to outperform persistently. For example, value-oriented stocks (e.g., those having characteristics such as low P/E ratios, high book value-to-market value multiples, etc.) have generated strong consistent outperformance of growth-oriented stocks over time. Eugene Fama and Ken French were among the first to highlight the value factor in 1992 in a seminal paper. Fama and French and others have also highlighted how small caps have outperformed large caps. Besides the value and size factors, several other factors, or styles, have generated statistically significant premiums over long periods of time, including liquidity (e.g., the tendency for less liquid securities to perform better than those that are more liquid), defensive (e.g., stocks that are high quality outperform those of lower quality) and asset growth (e.g., stocks of companies with robust growth in assets underperform those having lower growth).
Momentum has been another style that has performed very well, but hasn’t received the widespread publicity of value and size. The intuition behind momentum as a strategy is that assets that have performed well recently tend to continue to perform well, and conversely, those that have underperformed tend to continue to underperform. In an important 1993 paper, Jegadeesh and Titman first called attention to the momentum factor. In 1997, Carhart added momentum as a factor to the Fama-French three-factor (i.e., market, value and size) model for understanding performance persistence in mutual funds. Like many of the other factors, momentum is evident across many asset classes, including equities, bonds, currencies and commodities.
Momentum portfolios are generally implemented in one of two ways. Some institutional managers will construct long-short portfolios whereby they go long a group of stocks that have been top performers over the recent past, and go short a group of bottom performers. Such a long-short portfolio captures the momentum premium, and has little if any correlation with traditional asset classes. Some managers, such as AQR, have created portfolios extracting momentum across a diverse set of asset classes, which because of the lack of correlation, creates an overall strategy with attractive risk-adjusted returns. The other primary way of implementing a momentum strategy is simply to go long the group of recent top performers, foregoing the short portfolio. While this strategy has significant beta exposure, it is more easily implemented for investors who either cannot, or prefer not to, use short positions.
The graph below shows the performance of the top decile stocks (“winners”), the bottom decile stocks (“losers”), and the long-short portfolio of “winners” minus “losers” over the period covering January 1927 through July 2013.
Weekly Market Highlights:
- Domestic stock prices ended the week sharply lower. Stock prices reacted negatively to positive economic data this week, including a surge in retail sales, with a belief that the improving economy may accelerate the beginning of the Fed’s tapering program. In addition, profit-taking was also evident, as investors seek to book profits before year-end as the S&P 500 is up about 24% so far this year.
- Global markets were mostly lower for the week. World markets were also very soft on concerns the Fed may elect at its meeting next week to begin tapering its bond-buying program. UK stocks declined for the sixth straight week, with investors locking in profits. China stocks have declined four consecutive days in advance of next week’s meeting of the country’s economic policy makers.
- Treasury prices were little changed this week. The yield on the benchmark 10-year U.S. Treasury was marginally lower as investors await the outcome of next week’s Fed meeting.
- Commodity indices were modestly higher on the week. In the energy sector, crude oil declined, but natural gas surged; gold rose modestly; and grains were mixed.
Around 50%
That’s the share of users who finished a season (up to 22 episodes) of a TV show within a week, according to Netflix data, adding to evidence that binge viewing is becoming a social norm.
96%
Investments in the average company’s pension plan are expected to be at levels that cover 96% of future obligations at the end of the year, according to a new estimate by J.P. Morgan Chase. That’s up from 77% at the end of last year—a figure that was essentially unchanged since the financial crisis of 2008.
(Source: Wall Street Journal)
History seems to support the idea that 2014 will be less historic than 2013. Since 1927, there have been 23 years in which the S&P 500 has risen 20% or more, according to Birinyi Associates. It averaged a further gain of 6.4% in the next year. That is only slightly better than the 5.5% gain the S&P averaged for all years since 1927.
On only one of those 23 occasions of 20%-plus annual gains did the S&P improve its performance in the following year. In 1997 it rose 31% after a 20% gain in 1996. It rose again in 1998, by 27%, and in 1999, by 20%. Those were the days.
The S&P 500 has been known to decline in the year after a 20% gain. That has happened eight times. Six times it put in another 20% gain.
Data comparing the expansion of the S&P 500’s price/earnings ratio with past years, and comparing the performance at the current stage in the economic cycle, suggest gains of 6% to 9%.
It is possible that 2014 will be another year like 1997 and stocks will rise even faster than in 2013. Many in the market think the new Fed chairwoman, Janet Yellen, slated to take office Feb. 1 pending Senate confirmation, will delay withdrawing stimulus and fuel another big market year.
But before betting that 2014 will be better than 2013, investors might consider that it has happened once since 1927.
(Source: Wall Street Journal)
