Momentum indicators are commonly used to find winners. Winners are stocks with comparatively higher price returns. In normal market conditions, momentum indicators work well on an aggregate basis. Momentum indicators can lose their usefulness in turbulent market conditions, in the initial rebound period following a bear market or during slowing economic conditions.
I’ve noticed the “crashing” of momentum indicators as I backtest elements of the new stock strategy I’ve been working on. As some of you might recall, I’m developing a new strategy that combines value and momentum. The process has been going slower than expected, but I recently backtested components of the strategy through the financial crisis of 2008 and the spring of 2009. The data revealed periods where momentum indicators either didn’t work or did more harm than good.
There are different momentum indicators, but I’ll start with one that the anomaly called WML (winners minus losers) is most associated with: relative price strength. Relative price strength compares a stock’s returns over a given period of time (e.g., 26 or 52 weeks) to all other stocks. The more a stock has appreciated relative to a broad market index or all stock universe, the higher its relative price strength is. Price performance is considered an anomaly, because if the market were efficient (meaning excess return cannot be realized through the analysis of individual securities), an investor should not be able to create a portfolio out of the stocks with the best relative price strength and realize a market-beating return. Yet there is research showing that stocks that have performed well in the past will continue to perform well over the next one to two years. Academic research also shows that a profit can be made by buying “winners” and shorting “losers,” hence the WML acronym.
During and coming out of a bear market, relative strength can backfire. This is because sentiment shifts. The “losers” can suddenly be in favor as short sellers cover their positions and/or value-oriented investors attempt to buy stocks near what they foresee as the bottom of a turbulent market. Evidence of this occurring can be seen in the AAII stocks screens performance in December 2008. Two low relative-valuation-only screens handedly beat the returns of a momentum-only screen with returns of 9.7% and 11.3% versus 3.4%. (The all-stock universe rebounded strongly after being down significantly in November 2008.) The underperformance of momentum was also very evident in April 2009 (a month after the bear market ended), when the momentum screen trailed the two value screens by nearly 20 percentage points (a gain of 10.1% versus gains of 28.9% and 28.2%).
My momentum criteria combines both a 26-week relative price strength rank of at least 60% and no downward earnings estimate revisions. Relative price strength rank puts stocks into percentile rankings of 0 (worse) to 99 (best) based on their relative strength scores. Earnings estimate revisions are a momentum indicator because upwardly revised earnings forecasts often lead to higher future prices, while downwardly revised earnings estimate revisions often lead to lower future prices.
A challenge to using earnings estimate revisions during periods of economic weakness is the higher number of downward revisions. This isn’t surprising given that lousy economic conditions are not conducive to profit growth. From a screening perspective, attempting to require positive revisions or at least requiring no negative estimate revisions can lead to fewer companies passing even a relatively basic screen.
Mixing momentum and valuation in a stock screen during a bear market becomes even more troublesome when relative valuation indicators are used. Relative criteria generally identify approximately the same number of stocks in all market environments. As long as the universe stays relatively unchanged, the number of stocks with a price-to-sales ratio in the bottom 40% will stay relatively unchanged. What will change is the actual price-to-sales ratio defining the difference between the 40th lowest percentiles and any percentage ranking above it. A stock’s valuation has to be much lower to make it into the bottom 40% during a bear market than it does during a bull market (e.g., the median price-to-sales (P/S) ratio was 1.7 in September 2007, but just 0.7 in February 2009.) One way around this problem is to use absolute instead of relative valuation criteria during turbulent market conditions.
A similar type of problem was evidenced in our CAN SLIM screens. Between September 2008 and June 2009, few—and often no—stocks passed the screens. The culprit was a requirement for stocks to trade within 90% of their 52-week highs. Percentage of 52-week high is another “winners” criterion; it is used to identify only those stocks trading at or near their recent highs. Since bear markets drag down the prices for the overwhelming majority of stocks, the pool of stocks trading near their 52-week highs becomes limited during those turbulent market periods. Adding any additional criteria to a screen restricts the number of passing stocks even further and can cause a momentum-oriented stock screen to not identify any stocks.
None of this is a criticism of momentum. Rather it shows that momentum, like any other anomaly (low valuation, smaller company size, etc.), doesn’t work all the time.
- Why Momentum Strategies Can Crash – A study showed that fund momentum strategies particularly fail when the two-year market return is negative.
- Money from Momentum: Positive Feedback Can Drive Returns – The reasons why momentum works, as well as the anomaly’s limitations.
- Do You Adjust Your Momentum Strategies in Down Markets? – Tell us on the AAII.com Discussion Boards.
Approximately 115 members of the S&P 500 will report earnings. Included in this group are Dow Jones industry average components Exxon Mobil Corp. (XOM) and Pfizer (PFE) on Tuesday and Merck & Co. (MRK) on Wednesday.
The first economic reports of note will be the January ISM manufacturing index, December personal income and saving, the January PMI manufacturing index and December construction spending, all of which will be released on Monday. Wednesday will feature the January ISM non-manufacturing index and the January ADP Employment Report. The first estimate of fourth-quarter productivity and December factory orders will be released on Thursday. Friday will feature the January jobs report—including the change in nonfarm payrolls and the unemployment rate—and January international trade.
Two Federal Reserve officials will speak: Kansas City president Esther George on Tuesday and Cleveland president Loretta Mester on Thursday.
- The Changes to Social Security Claiming Strategies
- The Mathematics of Retirement Portfolios
- Social Security Strategies for Couples
Pessimism backed down from its nearly three-year high, but four out of 10 individual investors remain bearish in the latest AAII Sentiment Survey. Optimism jumped, while neutral sentiment rose slightly.
Bullish sentiment, expectations that stock prices will rise over the next six months, surged 8.2 percentage points to 29.8%. Though at a nine-week high, optimism is below its historical average of 39.0% for the 45th out of the past 47 weeks.
Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, edged up 0.5 percentage points to 30.3%. This is the first time neutral sentiment is below its historical average of 31.0% on consecutive weeks since December 25, 2014 through January 1, 2015.
Bearish sentiment, expectations that stock prices will fall over the next six months, pulled back by 8.7 percentage points to 40.0%. This is the first time pessimism has been at or above 40% on three consecutive weeks since October 18 through November 1, 2012. This is also the sixth time in the past seven weeks that bearish sentiment is above its historical average of 30.0%.
A stabilizing of stock prices over the past seven days likely helped to reduce the level of pessimism in our survey. Nonetheless, many individual investors still anticipate further declines. The slowing pace of economic growth in China, escalating tensions in the Middle East, the pace of economic growth in the U.S., the rate of earnings growth and prevailing valuations are all influencing investor sentiment. Though some individual investors view the current correction as a buying opportunity, optimism about the short-term direction of stock prices has not exceeded 30% since Thanksgiving.
The survey results were largely collected before the release of yesterday’s Federal Open Market Committee statement.
This week’s special question asked AAII members about their comfort level with the current valuation of stocks. Nearly one in three respondents (32%) said they view stocks as still being overvalued, somewhat high or are otherwise not comfortable with prevailing valuations. Many of these respondents don’t think corporate earnings justify current valuations, while several others pointed to Robert Shiller’s cyclically adjusted price-earnings (CAPE) ratio, which is at 24.0.
Conversely, 26% said stocks are undervalued or that they are comfortable with current valuations. Many of these respondents think the current drop has created a good buying opportunity.
Approximately 10% said valuations are reasonable or otherwise okay, while 5% said their perception of valuations depends on the stock or sector. A small group of respondents (4%) simply said they are anxious or nervous about current market conditions.
Here is a sampling of the responses:
- “Given how much stocks have dropped, it’s now time to buy.”
- “Way overvalued relative to the historical norms for the CAPE ratio.”
- “Depends on the stock. Some are still overvalued, while some are bargains.”
- “I am waiting to add more stocks as I think this price level is still too high.”
- “Too high given poor prospects for earnings growth.”
- “I welcome the correction. Many great quality stocks are now on sale.”
Bullish: 29.8%, up 8.2 points
Neutral: 30.3%, up 0.5 points
Bearish: 40%, down 8.7 points
Bullish: 39.0%
Neutral: 31.0%
Bearish: 30.0%
Local Chapter Meetings
January 21, 2016 Coping With the Frustrating Market
January 14, 2016 Guidance on What to Do If You Win the Lottery
January 7, 2016 China and Powerball Are Testing Our Financial Emotions
December 31, 2015 16 Investing Resolutions for the New Year
