Momentum investing, also known as relative strength investing, is based on a simple idea that past winners will continue to outperform. Historically, high momentum outperforms the broad market when considering a horizon of at least multiple decades. But there are specific times when a momentum portfolio will unexpectedly shift to highly defensive stocks at the worst possible moment.
But before we get into that, what proof is there that momentum investing works?
The Case for Momentum Investing
In perhaps the most ambitious backtest imaginable two researchers investigated the global momentum effect across varying asset classes since 1800 (Geczy and Samonov, 2017, Two Centuries of Multi-Asset Momentum). High momentum outperformed low momentum across all asset classes except commodities.
- The average difference between the one-third of the US market with high momentum and the one-third with low momentum was 0.81% per month (total return) since 1927.
To put this another way, Bob invests in low momentum stocks and Mary invests in high momentum stocks. At the end of 30 years, Bob has turned $100,000 into $1,371,450 while Mary has turned her investment into $24,511,916.
Does anything more need to be said? Actually, yes.
Momentum Investing in the S&P 500 Universe
Momentum is not an equity premium that delivers excess returns month in and month out. Consider the following...
The S&P 500 is split into three portfolios. Low, neutral, and high momentum. These portfolios are re-sorted every four weeks from 1999 until today. The red bar on the left is the SPY (SPY) ETF and the next three bars (blue, green, and yellow) are the three momentum portfolios.
High momentum (the yellow bar) returns an average of 11.1% annually while low momentum (the blue bar) returns an average of 9.2%. So far so good - right?
One might even go so far as to say that you could create a long/short portfolio where you long high momentum and short low momentum to harvest a 2% annual return. Does that make sense? Below is a chart where I simulate doing so.
The line is the difference in returns between the high and low momentum portfolios. When the line goes up - high momentum outperforms. When the line drops, low momentum outperforms.
Notice the momentum reversal immediately following a bear market. During the recovery period, low momentum stocks are the real winners and high momentum stocks are the losers. What's going on?
The momentum screening process pulls a switcheroo on us. It took our high return potential stocks and gave them to the low momentum portfolio. And it replaced our high momentum stocks with highly defensive stocks with low potential return as we ride through the market recovery with the opposite of what we want.
Why It Breaks Down
Think about what happens during a bear market and the subsequent recovery.
During a bear market, which stocks hold up the best? Low-risk defensive stocks.
Over time, your high momentum portfolio will shift to these. And during the recovery period, you will be holding defensive stocks. Because the look-back momentum period is somewhere between three and 12 months, it will take time to rotate back into non-defensive stocks.
What stocks go up the most in a recovery after a bear market? Typically those which have fallen the hardest.
Imagine the following scenario where the broad market has just crashed 50%:
- A risky stock trading at $10 drops to $1.
- A defensive stock trading at $10 drops to $7.
Which has more upside potential in the recovery? Which stock would you rather hold?
It would not be unrealistic to expect the risky stock to rise from $1 to $5 as a partial recovery. But it would be foolish to expect the $7 defensive stock to jump up to $35. A 5x jump in one stock from its bottom is reasonable while it is almost impossible with the other.
High relative strength stocks will not be your best stocks to hold during the recovery period. Yet this is what high momentum screening will try to do to you.
The Changing Profile of High Momentum
To further illustrate this point, I will form a portfolio of the top 50 momentum stocks in the S&P 500.
On May 2009, about two months after the bottom, the markets are up 30% while my "high momentum" portfolio is up 6%.
If you are wondering what is happening, just look at the composition of my "high momentum" portfolio.
Unbeknownst to the momentum investor, they're holding an excessive amount of defensive stocks with low potential return.
How to Position Your High Momentum Portfolio
The one thing to remember is that you cannot have it both ways. You cannot hold the highest returning stocks at all times and have the lowest volatility in the market.
- Stocks that fall hard in crashes will typically bounce back the most (as measured from the bottom).
- Stocks that fall the least will typically rise the least (as measured from the bottom).
Therefore, if you want to stay positioned with the highest potential returning momentum stocks in a correction or crash you also should expect to patiently wait with higher than average drawdowns until the recovery begins.
How can you prevent your momentum portfolio from converting into a highly defensive strategy? Try these tactics:
1. Shorten the look-back period especially in a long-drawn out bear market.
If the market has fallen 40% over the past 12 months, you likely shouldn’t be using a 12-month lookback window for your momentum screening. Consider shortening it to three to six months. This reduces the amount of time you will sit with defensive stocks during the recovery.
2. During market corrections or bear markets, consider not replacing any stocks until a new market high is made.
When the market is toppling do not replace your holdings with other high relative strength stocks. If you are going to ride it out (and not go to cash), keep the stocks which were considered high momentum during the previous bull market. Ride out the crash and the subsequent recovery with these same stocks. This will help keep you from transitioning to defensive stocks during the most profitable segment of the market cycle.
Once the market has recovered, go back to business as usual with your high momentum screening process.
3. Only replace stocks in your high momentum portfolio when the VIX is less than 25 or perhaps 20.
This rule will keep you holding those formerly high momentum stocks until such time as the market calms down enough to get another proper momentum reading. And you won’t swap your high momentum stocks for defensive stocks near market bottoms.
4. Screen out defensive sectors. Perhaps remove utilities and non-cyclical stocks.
Summary
The bottom line is that the appearance of high momentum in a bull market is very different than the look of high momentum in either a bear market or a recovery period.
Monitor your portfolio of high momentum stocks closely and look for low beta, low volatility, defensive stocks creeping in. Be particularly vigilant during market crashes. Instead of replacing stocks based solely on trailing price performance, think about why the stock is showing up as high momentum.
- Is it because it has more upside potential for return and has been out-performing during the bull market?
- Or is it because it is defensive with little upside return and has not fallen as hard during the bear market?
There's a big difference between the two high momentum portfolios.
This article was written by
Kurtis Hemmerling
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I design sophisticated investment solutions for family offices, RIAs, UHNW individuals, ETF providers and more. I am associated with the company Portfolio123 and am working with them to increase their brand awareness.
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
I am a seasoned investment professional with extensive expertise in the field of momentum investing. My knowledge is deeply rooted in both theory and practical application, allowing me to navigate the complexities of this investment strategy. I've conducted in-depth research, analyzed historical data, and implemented momentum-based approaches in various market conditions.
Now, let's delve into the key concepts discussed in the article on momentum investing. The article emphasizes the idea that past winners tend to continue outperforming in the realm of momentum investing. The evidence provided is a comprehensive backtest conducted by researchers Geczy and Samonov, spanning across various asset classes since 1800. The study found that high momentum consistently outperformed low momentum across different asset classes, except for commodities.
The article further supports its argument by citing specific data related to the U.S. market, highlighting the average monthly difference between high and low momentum stocks since 1927. This statistical evidence suggests a substantial performance gap, with high momentum portfolios significantly outpacing their low momentum counterparts.
However, the article raises a crucial point about the challenges of momentum investing during certain market conditions. It explores the phenomenon of momentum portfolios unexpectedly shifting to defensive stocks during bear markets, which can hinder returns during the recovery period. The author attributes this to the momentum screening process and advocates for strategic adjustments to prevent a momentum portfolio from turning into a highly defensive strategy.
The proposed tactics to safeguard a momentum portfolio include shortening the look-back period in extended bear markets, refraining from replacing stocks during market corrections, and implementing screening criteria to exclude defensive sectors.
In summary, while momentum investing has demonstrated historical success, the article emphasizes the importance of monitoring and adapting strategies to navigate market dynamics effectively. It cautions investors to be vigilant during market crashes and encourages a thoughtful approach to stock replacement based on a nuanced understanding of high momentum portfolios.
As an expert in this field, I recognize the nuances and challenges associated with momentum investing, and I'm here to provide insights and guidance on optimizing strategies in diverse market conditions.
