Momentum strategies seek out stocks that have done well in the past (winners), though they can also short stocks with past poor returns (losers). The idea is to take advantage of the return premium from favoring winners over losers. Such strategies have their share of critics, however. Among the criticisms are that momentum is not exploitable by the average investor and that such strategies are more volatile.
Clifford Asness, Andrea Frazzini and Ronen Israel of AQR Capital Management and Tobias Moskowitz of the University of Chicago pushed back. In a paper published in the 40th anniversary issue of the Journal of Portfolio Management, they debunk the 10 “myths” they say exist about momentum. I’ll give a summary of their arguments here. For those who want to see the full paper and do not have access to the magazine, a version is available on the SSRN website.
Myth #1. Momentum Returns Are Too Small and Sporadic: Over long periods, momentum has performed better than small company size and value. During the period of 1927 through 2013, the return difference between small stocks and large stocks has averaged 2.9% annually, cheap versus expensive stocks has averaged 4.7% annually and the recent winners over recent losers has averaged 8.3%.
Myth #2. Momentum Can Only Be Exploited on the Short Side: A common method for studying return attributes is to go long one side of the factor (e.g., strong relative price performance) and short the other side (e.g., weak relative price performance). For a momentum strategy, this can be described as “up minus down” or “UMD.” If the performance advantage only came from shorting the loser stocks, momentum wouldn’t work for investors looking to own (“go long”) stocks. The authors’ analysis, however, found that almost half the UMD premium came from owning the winners. They wrote, “The long side is every bit as profitable as the short side.”
Myth #3. Momentum Is Stronger Among Small Caps Than Large Caps: In a previous paper, Israel and Moskowitz found no evidence that momentum is related to size. Rather, it is almost equally as strong across company sizes.
Myth #4: Momentum Is Seriously Limited by Trading Costs: Momentum does have a higher turnover than value does. Dollar trading costs can still remain quite low for a momentum strategy if some flexibility is used and prudent trading decisions are made.
Myth #5. Momentum Does Not Work for a Taxable Investor: The authors cited a prior study showing momentum having the same tax burden as value, despite momentum having five to six times as much turnover. This seeming paradox occurs because momentum strategies sell losers (realizing short-term losses) and hold onto winners (resulting in more long-term gains being realized).
Myth #6. Momentum Is Not Useful as a Factor in Portfolio Construction, But Is Useful as a Screen: This argument says it is good to build a portfolio around size or value, but momentum should only be used as a restricting criteria in a screen. Asness et al. acknowledged the confusion of this type of argument. They described it as “an attempt to have your cake and eat it too.” They further wrote, “The problem is (as the saying goes) you can’t be a little bit pregnant. Either you believe in momentum and acknowledge the data, or you don’t.”
Myth #7. Momentum’s Returns Could Disappear: This line of reasoning is based on the concept that if a return premium is driven by investor behavior, then arbitrage forces may eventually eliminate it. Yet momentum has existed for a very long time and the adoption of it by institutional investors has not weakened its performance. Asness et al. further stated that even if the momentum premium actually did completely disappear, momentum would still be useful because of the diversification benefits it provides when combined with value.
Myth #8. Momentum Is Too Volatile to Rely On: Momentum strategies can experience periods of large losses, with the underperformance being worse for stand-alone momentum strategies. Spring 2009 was one such period. Yet other strategies also have periods of poor performance (e.g. value in 1999). On a risk-adjusted basis, investors are compensated for momentum’s relatively higher volatility.
Myth #9. Results for Momentum Change Based on the Measure Used: Asness et al. admit that this is actually true, but argued that it is false to view momentum as not being a stable process or to claim that it is possibly data-mined. (Data mining means looking for data to justify a preset belief.) The authors argue, “The notion that different measures can give different results is true with any strategy, because there are often several valid ways of measuring the same phenomenon. For instance, value measures usually contain some form of fundamental value-to-market value such as earnings-to-price, cash-flow-to-price, or book-to-market value. And, guess what, although all are effective over the long term, they give different results over any given period!”
Myth #10: Momentum Has No Theory Behind It: Though there is debate as to why momentum exists, theories do exist. There just isn’t a consensus. The two biggest camps are behavioral (an underreaction or a delayed overreaction phenomenon) and risk-based (momentum compensates for perceived risk). The authors didn’t show a preference for either theory. Rather, they opined, “For the practical investor, the distinction is far less relevant. Why? Because both the risk- and non-risk-based explanations provide an economic reason for the premium to exist and, what’s important, persist.”
Though I personally incorporate momentum into my personal strategy, I am the first to say that momentum is not something that should be universally used. It can lead to higher transaction costs with micro-cap stocks, such as those held by our Shadow Stock Portfolio. It can also result in a larger number of transactions and greater price volatility than other factors. As is the case with any tool, it needs to be used in the right situations by the right person.
- Money from Momentum: Positive Feedback Can Drive Returns – Chasing performance can be a rational response by investors.
- Why Momentum Strategies Can Crash – This applies to Myth 8 above and explains the reason momentum strategies perform poorly when a bear market ends.
- Do You Consider Momentum When Looking at Stocks? – Tell us on the AAII.com Discussion Boards.
Medical Action Industries (MDCI) was acquired by Owens & Minor Inc. (OMI) on October 1, 2014, triggering its removal from the Model Shadow Stock portfolio. Additionally, after the close of the market on October 31, 2014, Kimball International (KBAL) spun off its electronics division, resulting in shares of Kimball Electronics that trade under the symbol ‘KE’ in the portfolio. For the present time, shares of Kimball Electronics will remain in the portfolio.
The Model Shadow Stock Portfolio’s 3.2% gain in October trailed its comparison benchmarks: The Vanguard Small Cap Index (NAESX) was up 4.5%, and the DFA US Micro Cap Index fund (DFSCX) was up 6.5%. Year-to-date, the Model Shadow Stock Portfolio has declined 7.4%, trailing the Vanguard Small Cap Index fund (up 5.0%) and the DFA US Micro Cap Index fund (up 0.3%). The Model Shadow Stock Portfolio has a compound annual return of 17.1% since its inception in 1993, while the Vanguard Total Stock Market Index fund (VTSMX) has gained 9.4% annually over the same period.
The Model Fund Portfolio’s 3.0% gain last month compares to a gain of 2.7% for the Vanguard Total Stock Market Index fund. Year-to-date, the Model Fund Portfolio is up 8.3%, while the Vanguard Total Stock Market Index fund is up 9.8%. The Model Fund Portfolio has a compound annual return of 9.4% since inception in June of 2003, matching the performance of the Vanguard Total Stock Market Index fund over the same time period.
The U.S. financial markets will be closed on Thursday in observance of Thanksgiving. On Friday, the U.S. equity markets will close early, at 1:00 p.m. ET. Our offices will be closed on both Thursday and Friday. Neither this email (Investor Update) nor the weekly updates for the Stock Superstars Report and AAII Dividend Investing will be mailed out next week.
Just seven members of the S&P 500 will report earnings next week. They are Analog Devices, Inc. (ADI), Campbell Soup Company (CPB), Hewlett-Packard Company (HPQ), Hormel Foods Corp. (HRL), Pall Corp. (PLL) and Tiffany & Co. (TIF) on Tuesday; and Deere & Company (DE) on Wednesday.
Nearly all of the notable economic data will be released on Tuesday and Wednesday. Tuesday will feature the first revision to third-quarter GDP, the September Case-Shiller home price index and the Conference Board’s November consumer confidence index. October durable goods orders, October personal income and spending, October new home sales, October pending home sales and weekly jobless claims will be released on Wednesday. The November Chicago PMI will be the exception, with a Friday release date.
The Treasury Department will auction $28 billion of two-year notes on Monday, $35 billion of five-year notes and $13 billion of floating rate two-year notes on Tuesday, and $29 billion of seven-year notes on Wednesday.
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Optimism pulled back from a four-year high, falling below 50% for the first time this month in the latest AAII Sentiment Survey. Neutral sentiment rebounded and pessimism rose for the second consecutive week.
Bullish sentiment, expectations that stock prices will rise over the next six months, fell 8.8 percentage points to 49.1%. The drop puts optimism at a five-week low. Nonetheless, bullish sentiment remains above its historical average of 39.0% for the seventh consecutive week and the 14th out of the past 15 weeks.
Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rebounded by 4.3 percentage points to 27.1%. Even with the increase, neutral sentiment remains below its historical average of 30.5% for the seventh time in the past nine weeks.
Bearish sentiment, expectations that stock prices will fall over the next six months, rose 4.5 percentage points to 23.8%. The rise was not large enough, however, to prevent pessimism from being below its historical average of 30.5% for the fifth consecutive week and the 38th week this year.
Seeing a bit of reversion to the mean is not unexpected given how high optimism was last week (57.9%, the 58th-highest reading in the survey’s history) and how low pessimism was on November 6, 2014 (15.1%, a nine-year low). Optimism remains at a very high level this week, however. Bullish sentiment is right at the border between what is typical and what is unusually high. Viewed in another manner, optimism is above 49% and pessimism is below 25% for the fifth consecutive week.
The sustained high level of optimism is occurring as the S&P 500 has risen by 10% since hitting a 2014 closing low on October 15. In addition to the avoidance of a correction and the strong rebound in equity prices, individual investors are also encouraged by falling energy prices, earnings growth, the Federal Reserve’s ending of its bond purchasing program and sustained economic expansion. Some AAII members may also be reacting to the outcome of the midterm elections. Keeping other AAII members cautious are geopolitical events, a sense that prevailing valuations are too high and the pace of economic growth.
This week’s special question asked AAII members how they think the average consumer is faring relative to a year ago. Slightly more than half of respondents (53%) said the average consumer is doing better, though many of them described the consumer as only doing somewhat or a little better. Gas prices were the top reason given as to why, though several respondents mentioned employment and/or economic growth. Roughly the same number of respondents (about 15% each) said the average consumer is faring about the same as last year or is faring worse. Though the decline in gas prices are viewed as a positive, stagnant wage growth and inflation in other areas were cited as headwinds.
Here is a sampling of the responses:
- “Better. The economy is improving and oil prices are falling.”
- “Better in part to more employment, falling heating and driving costs and the housing recovery.”
- “Somewhat better due to lower unemployment, modest wage gains in some areas and lower fuel prices.”
- “May be helped by lower gasoline prices, but is also facing rising food and housing prices.”
- “Not much better. Job growth, and, more importantly, income growth has been slow.”
Bullish: 49.1%, down 8.8 points
Neutral: 27.1%, up 4.3 points
Bearish: 23.8%, up 4.5 points
Local Chapter Meetings
November 13, 2014 A New Argument Against Long-Term Care Insurance
November 6, 2014 Are Simpler Stock Strategies Better?
October 30, 2014 I Rebalanced My Portfolio
October 23, 2014 The SEC Says “No!” to Next-Generation ETFs