- The momentum factor is based on the notion that upward moving stocks tend to continue moving in that direction over the short term, and vice-versa.
- Momentum strategies are vulnerable to being whipsawed when the stock market has been heading in one direction and then suddenly reverses direction.
- The risk of being whipsawed can be reduced by including a mean-reversion component in a momentum-oriented strategy, as is the case with The Milwaukee Company’s Sector Rotation Strategy.
I find the great thing in this world is not so much where we stand, as in what direction we are moving: To reach the port of heaven, we must sail sometimes with the wind and sometimes against it – but we must sail, and not drift, nor lie at anchor.
– Oliver Wendell Holmes, Sr.
Last week’s post discussed the potential for a portfolio invested in index-tracking exchange traded funds that target certain risk factors to outperform a portfolio of market-weighted index funds. In that post I mentioned that we would take a closer look at some of the factors that have a great deal of academic support. The first factor I would like to discuss is the momentum factor.
The momentum factor refers to the tendency for securities that have recently outperformed to continue to perform well (and the tendency for securities that have underperformed as of late to continue to underperform) over the short term. Stock prices over the previous two to twelve months are commonly used to measure momentum.
While the existence of a momentum premium was first proposed in an academic paper published in 1993, it has been suggested that there’s been a momentum premium in U.S. equities dating back to 1801, and in the United Kingdom “dating back to the Victorian age”.
The most widely accepted rationale for the existence of the momentum premium is that investors tend to over-react to news about the economy, the markets, or individual companies, and this irrational exuberance or pessimism causes prices to move up or down more than they otherwise would. However, over the longer term, prices tend to revert to their fair values after the initial emotional response fades. The latter concept is referred to as “mean reversion”.
One of the attractive aspects of a momentum strategy is how easily it can be implemented, which makes it well-suited to do-it-yourselfers. For example, one of the most popular momentum strategies is Mebane Faber’s 10-month simple moving average strategy. The following is an example of how Mr. Faber’s strategy can be applied to S&P 500 sector funds:
- When the S&P 500 moves above its 12-month moving average, buy the top three sectors with the largest gains over the previous three months.
- Rebalance on a monthly basis, selling the sectors that fall outside the top three and buying those who move into the top three.
- Sell all holdings when the S&P falls below its 12-month average.
In an earlier post you can find here, I discussed the risk of being whipsawed with a momentum strategy when the stock market is heading in one direction and then suddenly reverses direction, as demonstrated recently by the underperformance of momentum during the market’s sharp decline in the fourth quarter of 2018 and the January rally that followed. Despite its potential for short-term volatility, momentum has an encouraging record over the longer term. (A comparison of the performance of smart-beta strategies, including momentum, can be found in The Milwaukee Company’s weekly Smart Beta Report.)
The unfortunate potential of a momentum strategy to be whipsawed means that investors need a lot of discipline to profit from this risk factor – particularly if it’s used in isolation. On the other hand, whipsaw can be mitigated by utilizing both momentum and mean reversion in a single strategy. The Milwaukee Company’s Sector Rotation Strategy is an example of such an approach.
In next week’s post I will be taking a closer look at the “value factor,” which refers to favoring securities are that currently out-of-favor, and therefore priced at a discount to their fundamental value. Value stocks have historically outperformed the shares of companies that are in vogue (and whose shares are priced at a premium as a result). The value factor’s edge may seem obvious, but as we’ll see next week there’s still a fair amount of debate about value’s role as a driver of investment performance.
As for momentum, the concept’s origin is linked to physics. French scientist and philosopher Descartes was the first to define the momentum (or the degree of motion) of a moving body as the product of its mass and velocity. This video illustrates the incredible power of momentum when planetary bodies collide in space. While collisions during the process of price discovery on Planet Earth are certainly less dramatic, the power of financial mass and velocity in asset pricing is most certainly not a force to be taken lightly.
Thank you for reading.
The Market Commentator