Momentum strategies targeting stocks with relative outperformance have been shown to boost returns during normal market conditions. During the initial stage of a new bull market, however, these strategies lose their edge. The decline in performance can be dramatic and occurs as a rotation in preferences favors past losers over past winners.
Professors at Columbia University and the Booth School of Business called these occurrences “momentum crashes.” They point to the end of the 2007–2009 bear market and the start of the subsequent bull market as an example. During the period of March through May 2009, stocks ranking in the bottom decile for past performance (low relative strength) gained 163%. Conversely, stocks in the top decile (high relative strength) gained just 8%.
Such lousy performance is typical following periods when the lagged two-year market return is negative, according to the authors. Fourteen of the 15 worst momentum crashes occurred during such periods. All momentum crashes happened when “the market rose contemporaneously, often in dramatic fashion.” In a portfolio going long the stocks with the strongest relative price strength and short the stocks with the weakest relative price strength rank, “the short side of the portfolio—the losers—are ‘crashing up’ rather than down.”
Beta, a measure of a stock’s volatility, is a key characteristic of these momentum crashes. During a bear market, shares of defensive or counter-cyclical companies are favored. When a rebound begins, significant upside volatility occurs. This can push the beta of the winners portfolio (composed of stocks with the best past returns) above 2.0. The beta of the losers portfolio (made up of stocks with the worst returns), however, can jump up to 4.0 or 5.0. Higher betas imply greater volatility in the share price. During periods characterized by a strong upward market move, holding high beta stocks can lead to higher returns.
Put another way, a momentum portfolio that is long winners and short losers has significant negative market exposure near the end of a bear market. While this can make the bear market more tolerable by reducing the downside (aka “drawdown”), it leaves the portfolio with significant negative market exposure when the market rebounds significantly upward. The authors say this exposure is “even more negative for extreme past return sorted portfolios.”
Source: “Momentum Crashes,” Kent Daniel and Tobias Moskowitz, National Bureau of Economic Research, August 2014.
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O. Timothy Moore from OR posted over 11 years ago:
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