As investors have embraced factor-based equity strategies, the price momentum factor has been one of the most favored in recent years.
What’s the basic idea behind momentum investing? Stocks that have gone up and outpaced the market recently should continue to do well in the months ahead—and vice versa. This concept is rooted in decades of academic research that suggests markets initially underreact to improving—or deteriorating—company-specific trends, thereby providing alert investors with an opportunity to pursue a momentum premium by buying and holding stocks that have risen recently, while trying to avoid or sell stocks that have fallen recently.¹ Momentum stocks tend to shine in upward-trending markets, particularly those characterized by low levels of price volatility. Such was the case in 2017, as synchronized global growth, strong corporate earnings, and accommodative monetary policy lifted stocks steadily higher. This benign backdrop rewarded market participants of all kinds, but momentum investors enjoyed an outsize share of the gains.
What works best on the way up may hurt most on the way down
Indeed, buying rising stocks and selling falling stocks works well—until it doesn’t. When smooth up markets become choppy sideways markets, momentum investors tend to find themselves in a challenging position. Drawdowns for the momentum factor can be much sharper than those for the broader market when conditions deteriorate. We saw examples of this last year, as markets responded to sharp changes in investor sentiment, often prompted by developments related to global trade or U.S. Federal Reserve (Fed) policy. The S&P 500 Index declined 19.8% from September 20, 2018, through December 24, 2018, just basis points shy of the technical definition of a bear market. Unsurprisingly, the highest-flying stocks, when conditions were favorable, ended up falling the most as the market’s decline deepened. Prices have since rebounded, and the first quarter of 2019 has been much kinder to investors. Still, the extended streak of smooth, steady gains has clearly been disrupted.
Another challenge for momentum investors: not realizing what you own
More subtle challenges for momentum investors may stem from market leadership that can change quickly and unpredictably when stock price action gets choppy. The composition of a basket of momentum stocks can change meaningfully as market volatility rises, leading investors to unintended exposure. In recent months, the sector exposure of the MSCI USA Momentum Index, expressed relative to the S&P 500 Index, has undergone significant shifts. Upward price momentum has migrated away from some industries and toward others. Information technology represented momentum’s largest overweight in 2018, but it was the worst-performing sector in the fourth quarter; as a result, it’s been relegated to below-market exposure in the momentum universe. Instead, momentum investors are now—perhaps unwittingly—making their largest active sector bets in utilities, consumer staples, and healthcare. Whether investors like it or not, this line of positioning represents an unintended consequence of index rebalancing in many cases. This changing of stripes has come at a cost, too: January 2019 to the date of this writing, technology has handily outperformed utilities, consumer staples, and healthcare.
If momentum investing really has lost its mojo, what now?
Has the time for momentum investing passed? More than a decade into this bull market—already the longest on record—it’s probably prudent to assume momentum investing’s best days of this cycle are behind us. U.S. economic growth remains positive but slowing, and corporate earnings are no longer accelerating. A more dovish Fed may provide support for stocks over the near to intermediate term, but a balanced, more cautious approach to risk is now warranted, in our view.
Large losses are painful under most circumstances—but especially when your portfolio suffers from risks different from those you set out to take. As we believe we’re late in the cycle, our outlook calls for a neutral position in equities, with a tilt toward the quality factor and away from momentum. Our latest research drawing on historical data points to quality among more promising factors for late-cycle investing environments. Moreover, when quality is combined with the small-cap premium, it can represent a more stable approach—relative to momentum—to seeking the market’s upside in a mature phase of the business cycle.
1 “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency,” Journal of Finance, March 1993.