The Economist Looks at Momentum

The Economist highlights one of my favorite topics—momentum investing. Many studies have shown that once a stock gets going in one direction, the chances are very good that it will keep going. This is something that any practitioner can tell you is obviously true, yet it conflicts with how academics prefer to see the market:

What goes up must come down. It is natural to assume that the law of gravity should also apply in financial markets. After all, isn’t the oldest piece of investment advice to buy low and sell high? But in 2010 European investors would have prospered by following a different rule. Anyone who bought the best-performing stocks of the previous year would have enjoyed returns more than 12 percentage points higher than someone who bought 2009’s worst performers. This was not unusual. Since the 1980s academic studies have repeatedly shown that, on average, shares that have performed well in the recent past continue to do so for some time. Longer-term studies have confirmed that this “momentum” effect has been observable for much of the past century. Nor is the phenomenon confined to the stockmarket. Commodity prices and currencies are remarkably persistent, rising or falling for long periods. The momentum effect drives a juggernaut through one of the tenets of finance theory, the efficient-market hypothesis. In its strongest form this states that past price movements should give no useful information about the future. Investors should have no logical reason to have preferred the winners of 2009 to the losers; both should be fairly priced already.

Actually, it doesn’t necessarily drive a juggernaut through the efficient-market hypothesis. Believers in EMH can aver that it’s not the stock that’s following momentum but rather it’s positive news. This is precisely why EMH is hard to knock down–it can be very slippery.

Markets do throw up occasional anomalies—for instance, the outperformance of shares in January or their poor performance in the summer months—that may be too small or unreliable to exploit. But the momentum effect is huge. Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School (LBS) looked at the largest 100 stocks in the British market since 1900. They calculated the return from buying the 20 best performers over the past 12 months and then holding them, rebalancing the portfolio every month. This produced an annual average of 10.3 percentage points more than a strategy of buying the previous 12 months’ worst performers. An investment of £1 in 1900 would have grown into £2.3m by the end of 2009; the same sum invested in the losers would have turned into just £49 (see chart 1). Messrs Dimson, Marsh and Staunton applied a similar approach to 19 markets across the world and found a significant momentum effect in 18 of them, dating back to 1926 in America and 1975 in larger European markets. A study by AQR Capital Management, a hedge fund, found that the American stocks with the best momentum outperformed those with the worst by more than ten percentage points a year between 1927 and 2010 (see chart 2). AQR has set up a series of funds that attempt to exploit the momentum anomaly.

With any strategy like this, we need to be reminded that even if it works, any positive effects are difficult to capture due to trading costs, turnover and taxes. However, even adjusted for this, momentum still holds up.

What I find interesting is that momentum seems to conflict with the other major hole in EMH — value investing. Studies have also shown that stocks with lower valuations outperform the market. So stocks ignored by the market do well and stocks madly embraced by the market do well. Or does it mean that the outperforming value stocks are the momentum stocks? I’ve never been able to reconcile these two phenomena.

More from The Economist:

Once a trend is established, a share may benefit from a bandwagon effect. Professional fund managers have to prepare regular reports for clients on the progress of their portfolios. They will naturally want to demonstrate their skills by owning shares that have been rising in price and selling those that have been falling. This “window-dressing” may add to momentum. Paul Woolley of the London School of Economics has suggested that momentum might result from an agency problem. Investors reward fund managers who have recently beaten the market; such fund managers will inevitably own the most popular shares. As they get more money from clients, such managers will put more money into their favoured stocks, giving momentum an extra boost. It is hardly a surprise that the momentum effect has been exploited by some professionals for decades. Commodity trading advisers (CTAs), also known as managed futures funds, exist to exploit the phenomenon. They take advantage of trends across a wide range of asset classes, including equities and currencies as well as raw materials. Martin Lueck was one of the three founders of AHL, one of the more successful CTAs, and now works for another trend-follower, Aspect Capital. “Trends occur because there is a disequilibrium between supply and demand,” he says. “The asset is trying to get from equilibrium price A to equilibrium price B.” Many of the trend-following models were developed in the late 1970s and early 1980s. They were exploited by investors such as John Henry, best known outside the financial world for owning a baseball team, the Boston Red Sox, and a football club, Liverpool (which is on a downward trend of its own). One of the simplest was to buy an asset when the 20-day moving average of its price rose above its 200-day average. In a recent study Joëlle Miffre and Georgios Rallis of the Cass Business School in London found 13 profitable momentum strategies in commodity markets with an average annual return of 9.4% between 1979 and 2004.

Here’s a look at long-term momentum returns by decile (10% slice). The data is from Ken French’s data library.

Notice that the market’s rally over the past two years has been strongly counter-momentum. Stocks that had been doing the worst gained over 265% in just seven months.

Posted by Eddy Elfenbein on January 20th, 2011 at 9:05 am

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