Special note: Our offices will be closed this Monday and Tuesday, December 25 and 26, and on Monday, January 1. The U.S. financial markets will be closed the next two Mondays as well. On behalf of everyone at AAII, I wish you a merry Christmas and a very happy holiday season.

As we near the end of 2017, some of you may be thinking about tweaking your investing strategies. If so, I’d like to suggest giving value and momentum a consideration. They are two of the most persistent drivers of stock price returns. Although value and momentum seem like polar opposites and take turns outperforming each other, they make a great pair.

Value investing requires buying stocks at prices representing discounted multiples of earnings, book value, sales, cash flow, etc. Such stocks can be described as trading at valuations ranking in the bottom 40% of all stocks. Value works because investors do not expect these cheaper stocks to deliver good news or otherwise exceed expectations. This creates upside potential because there is more bad news than good news priced into such stocks. In comparison, growth stocks—stocks trading at high valuations—tend to have high expectations priced into them. These high expectations create more opportunity for the company to disappoint, leading to greater downside potential. This is why, over the long term, value beats growth.

Momentum requires buying stocks whose returns are better than the majority of other stocks. Traditional momentum strategies seek out stocks with comparatively high levels of relative strength. Relative strength is a stock’s price return over a given period—most commonly the last 13 to 52 weeks—compared to the return of all other stocks over the same period of time. Stocks whose relative strength rank is in the top 40% tend to continue outperforming.

On the surface, value and momentum would seem to be quite the odd couple. Value investors seek to buy stocks when they are on sale, and momentum investors seek to buy stocks when they are outperforming. Yet, like Felix Unger and Oscar Madison of the 1970s sitcom “The Odd Couple,” value and momentum are a good pair.

Since they seek different characteristics in a stock, combining value and momentum within a portfolio creates diversification. Sometimes value outperforms and sometimes momentum outperforms, as the chart on the right shows. If you have exposure to both, you increase your odds of being exposed to the factor currently in favor. Does it work? The 15-year annualized return for the S&P 500 High Momentum Value index was 14.2% as of September 2017—the highest of the 18 S&P 500 indexes S&P Dow Jones Indices track.

Combining them also takes advantage of market efficiency. When a value stock is outperforming, it is a sign that other investors also recognize the stock as being a bargain. This is why I like combining the two. Seeing a value stock rise in value gives me confirmation that the stock is truly on sale as opposed to being cheap for a reason.

No combination of factors works all the time or is right for every person. Momentum strategies can and do crash, particularly when the market begins to rebound from a steep decline. Value loses out to growth from time to time and leads you away from the glamour stocks most people are talking about. Plus, merely requiring value and momentum—and nothing else—results in too many stocks being identified for you or me to invest in.
Using value and momentum as cornerstones for a long-term strategy works well, however. This is how I use the two factors, and it may be something for you to consider if you’re thinking about tweaking your strategy.

• Five Common Traits of Success Value Screens – AAII president John Bajkowski revealed the common traits AAII’s value screens share.
• Momentum’s Role as a Driver of Stock Prices – A closer look at what the momentum factor is and how it has performed.

• Corporations Do Not Optimize Share Repurchases – Most corporations would realize higher returns if they simply used a dollar-cost averaging approach for buying back their shares.
• The Individual Investor’s Guide to Personal Tax Planning 2017 – Our annual tax guide has the information you need to start your year-end tax planning and begin planning for 2018.

The addition of a new “four-year rule” to the AAII Model Shadow Stock Portfolio led to the deletion of Key Tronic Corp. (KTCC), Salem Media Group Inc. (SALM), Shoe Carnival Inc. (SCVL) and VOXX International Corp. (VOXX). The four-year rule requires stocks that have been held for more than four years to be sold unless:

• they still currently qualify as a shadow stock,
• they are up 40% or more from their purchase price, or
• there is no qualifying stock to replace them.

In addition, Alamo Group Inc. (ALG) was sold for violating the portfolio’s value and size rules and Global Power Equipment Group (GLPW) was sold for violating the portfolio’s earnings rule.

Replacing the aforementioned stocks are The New Home Company (NWHM), Olympic Steel Inc. (ZEUS), Aceto Corp. (ACET), AutoWeb Inc. (AUTO) and Big 5 Sporting Goods Corp. (BGFV).

The AAII Model Shadow Stock Portfolio, which is a real-money portfolio of micro-cap value stocks, gained 0.35% in November. By means of comparison, the DFA Micro Cap fund (DFSCX) posted a total return of 2.64% for November while the Vanguard Small Cap Index fund (NAESX) gained 3.08% for the month. Since its inception in 1993, the Model Shadow Stock Portfolio has a compound annual average return of 16.2% versus the Vanguard 500 Index fund’s (VFINX) annualized gain of 9.5%.

As noted above, the U.S. financial markets will be closed on Monday, December 25, in observance of Christmas Day, and on January 1 for New Year’s Day.

No S&P 500 companies are scheduled to report earnings.

The week’s first economic report will be the October S&P Case-Shiller home price index, the Conference Board’s December consumer confidence survey and November pending home sales. All of these reports will be released on Wednesday. Thursday will feature November international trade data. The December Chicago PMI will be released on Friday.

The Treasury Department will auction $26 billion of two-year notes on Tuesday, $13 billion of two-year floating rate notes (FRNs) and $34 billion of five-year notes on Wednesday and $28 billion of seven-year notes on Thursday.

Optimism among individual investors about the short-term direction of stock prices is at its highest level in nearly two years, according to the latest AAII Sentiment Survey. At the same time both neutral and bearish sentiment are lower.

Bullish sentiment, expectations that stock prices will rise over the next six months, rose 5.5 percentage points to 50.5%. Optimism was last higher on January 1, 2015 (51.7%). This is just the 11th week this year that bullish sentiment is above its historical average of 38.5%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, fell 3.0 percentage points to 23.9%. Neutral sentiment was last lower on March 9, 2017 (23.5%). The historical average is 31.0%.

Bearish sentiment, expectations that stock prices will fall over the next six months, declined 2.5 percentage points to 25.6%. Pessimism was last lower on November 9, 2017 (23.1%). The historical average is 30.5%.

Since hitting a near-term bottom of 29.3% on November 16, bullish sentiment has risen for five consecutive weeks. The cumulative increase over this five-week period is 21.1 percentage points. At the same time, neutral sentiment has fallen by a cumulative 11.6 percentage points.

At current levels, optimism is unusually high, meaning more than one standard deviation above its historical average. Historically, the S&P 500 has realized below-average and below-median returns over the six- and 12-month periods following unusually high bullish sentiment readings. An updated table with the historical readings can be found in my Investor Update commentary from last week.

The results for this week were tabulated after the Federal Open Market Committee’s latest meeting, but largely before the tax reform bill was passed. (As the results to this week’s special question show, the majority of individual investors agree with the decision to raise rates.) Our previous polling of individual investors showed that most were not currently making investment decisions based on the pending tax legislation. We’re following up to see if opinions have changed with the special question for the survey period starting today and running through next Wednesday.

This year’s record highs for the major U.S. stock indexes have encouraged some individual investors, though others have expressed concerns about the possibility of a pullback or a more severe drop occurring. Also affecting investor sentiment are earnings growth, economic growth, valuations and the lack of volatility. Washington politics remain at the forefront of many individual investors’ minds.

This week’s special question asked AAII members for their thoughts about the Federal Open Market Committee’s (FOMC) decision to raise interest rates for a third time this year. Nearly three out of five respondents (58%) expressed approval, mostly saying they agree with the hike, thought it was a good decision or was otherwise appropriate. Slightly more than a quarter of all respondents (26%) disagreed with the decision. Many of these respondents thought the FOMC was being too slow in raising rates. Nearly 14% of respondents described the rate hike as being expected.

Here is a sampling of the responses:

• “Good job, and go for more next year. Let’s normalize rates.”
• “I think it’s about time. Seniors have been losing out on their savings interest rates.”
• “The rates should have gone up earlier.”
• “It was due. Not likely a problem for the stock market, which I suspect was expecting it.”
• “A necessary and timely move.”
• “Don’t go any faster as inflation is not on the rise.”

Bullish: 50.5%, up 5.5 points
Neutral: 23.9%, down 3.0 points
Bearish: 25.6%, down 2.5 points


Bullish: 38.5%
Neutral: 31.0%
Bearish: 30.5%

AAII Local Chapter Meetings offer you a variety of presentations from expert speakers who will give you their view on the world of investing. A bonus of attending a Chapter Meeting near you is the opportunity to meet other AAII members who share your interest and enthusiasm for investing. You can even share the Chapter experience with your family and friends by inviting them to attend Chapter Meetings with you!

Archives
December 14, 2017 Optimism Has Been Low This Year, but Not Unusually So

December 7, 2017 Investors, Turn Down the Volume

November 30, 2017 The Senate’s Proposed Change to Recognizing Capital Gains

November 23, 2017 Reasons for Individual Investors to Be Grateful