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My view on what's going on in the financial markets and the global economy, and a few other things that might interest me from time to time.

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Momentum investing: not all it's cracked up to be

Updated: Jul 19, 2020

As the US equity markets head further north, almost without pause, it compelled me to look at an investment strategy that is not new but one that is getting a fair amount of press at the moment, mainly because it is fashionable in a one-directional market and – at least on the surface – appears to be working. I am referring to “momentum investing”. In a nutshell, this strategy simply entails “riding the winners and selling the losers”, or in other words, buying stocks that are going up (because they have upwards momentum) and shorting stocks that are going down. It is a purely technical strategy that reflects the simple rule that “the trend is your friend.” Momentum investing seems to be the polar opposite of value investing, the latter of which entails identifying stocks that have not appreciated (yet) but which have technical and fundamental aspects that should lead to appreciation once their true value is acknowledged by investors.

There are hedge funds, mutual funds and asset managers that invest using momentum strategies, and these funds seem to have had a good run recently in this one directional market aside from a hiccup in late August / September when some large cap stocks took a hit at the expense of value stocks (see “Momentum crash impacted hedge funds”). But having looked at this (with limitations I’ll address in a moment), I think momentum strategies might work for limited periods using a simple approach, but that more complex strategies seem to have underperformed a “buy & hold” strategy. Welcome to the world of efficient markets!

Momentum strategies involve “buy” and “sell” indicators that are developed by the investor or portfolio manager. They are normally employed around a portfolio of given stocks, in which buy / sell technical indicators are developed and used based on the closing prices of each stock in the portfolio. There are also indicators that I have read about (see Investopedia) that are used to play the market more broadly, and these include metrics like:

  • 50-day moving average vs 200-day moving average for an index, e.g. the S&P 500 index. Signals are “buy” when 50-day moving average is above 200-day moving average, and “sell” when 50-day moving average is below 200-day moving average

  • ETF sector strategy – buy sector ETF’s that are performing well and sell sector ETF’s that are performing poorly (here, you can clearly see it could be the opposite of a value approach, although fundamentals of the sector would also be considered in a value strategy)

  • Cross asset strategies, for which an example is given regarding the steepness of the 2-10 year UST yield curve as a signal to buy (steep) or sell (flat / inverted) an index or portfolio of equities

If you want to dig even deeper, this article from Corporate Finance Institute goes into more detail on select momentum strategies. However, the most important feature, regardless of strategy, is the choice of triggers representing an inflection point. This is far from a science, although I suspect portfolio managers that use this strategy might very well think otherwise.

Out of curiosity, I wanted to see what sort of performance a couple of these strategies might generate on a very simplistic basis, using the following assumptions:

  • Investment vehicle is the S&P 500 index (not a portfolio of individual shares, which is probably the more common approach), and

  • The period I considered is only five years (Jan 13, 2015 to Jan 10, 2020), not even a full US business cycle (although arguably there were some mini-cycles and “near misses” during this period).

I tested two strategies with different triggers:

  1. 50-day moving average of the S&P 500 index vs the 200-day moving average of the same index (former higher than latter is “buy” indicator). For this strategy, I employed two action steps, one using a “buy” or “sell and short”, and the other using a “buy” or ”sell and move to cash” (so not shorting with a “sell” indicator)

  2. Difference between the 2 year and 10 year UST’s (noting that a narrowing or inverted yield curve is signalling a recession in the period ahead)

This graph illustrates the first set of triggers (50-day moving average vs 200-day moving average), alongside the actual level of the S&P 500 index:

You can see that the actual index trends well ahead of the 50-day vs 200-day difference as one would expect, meaning that investors using this strategy are getting out too late in a market that is turning down (e.g. note sharp decline in 4Q2018, although “sell” signal didn’t come until mid-December), and getting in too late on a market that is trending up (1Q2019, in which market rose from early January but “buy” signal did not come until early April 2019). The “long-short” approach underperformed a “buy & hold” strategy regardless of the holding period (ranging from 1 to 5 years), whilst the “long-flat” approach performed about the same as a 5-year “buy & hold” and was better than a 3-year “buy & hold”, but otherwise significantly underperformed too, especially since the beginning of 2018.

The second strategy involved the shape of the yield curve. This graph illustrates the difference between the 2-year UST vs 10-year UST over the last five years:

As this graph illustrates, the spread between the 2-year UST and the 10-year UST has generally been declining during this period, with occasional blips toward widening (e.g. mid-2015, late 2016 and late 2019). The only true inversion was in late August-early September 2019, which received some press, although not as much as the steady narrowing throughout most of 2018. Although the curve did not invert in 2018, this steady narrowing throughout the year - to a low of 12bps on December 20, 2018 - was viewed as an almost-certain harbinger of a pending recession, which negatively affected the equity markets throughout 4Q2018. However, the recession never materialised (at least not yet), and the equity markets resumed their one-way march upwards in early 2019 as the curve widened.

I looked at three scenarios as far as the yield curve difference: flat/inversion (0bps or less), 10bps (positive) difference and 20bps (positive) difference. (The reality is that even the 20bps difference was rather rare during this period.) For each trigger point, I used a “long / short” strategy (as opposed to a “long / cash” strategy). Per annum returns, depending on the trigger, ranged from 10.3% (flat/inverted) to 10.7% (20bps difference or narrower) over the period starting from October 27, 2015 (so as to be the same test period as the 50-day vs 200-day equity index difference). As noted in the summary below, returns using a shape of the yield curve strategy were substantially better than the “long / short” equity momentum strategy. This table is a summary of both momentum strategies (and sub-variants) compared to a “buy & hold” strategy from the onset:

As far as I am concerned, the results speak for themselves in this narrow study - you would have been better off investing from the onset and holding throughout the period than employing a momentum strategy. But I must caution the reader to recognise that this is a very short term analysis over a period that has been basically upwards. If I get time (one day), I will go back further, because seeing how this works through a recession and / or prolonged down market might bring much more validation to a momentum investment strategy involving the S&P 500 index.

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Jan 17, 2020

Hi Dennis, probably it's too much time on my hands, but thank you for the kind comments re my blog! I think you are right in terms of market approach, although going to cash can be expensive (in terms of opportunity cost) when the market is running like it is at the moment, and has been more or less since early 2019. In times of concern, I generally put on admittedly imperfect hedges in the form of out-of-the money S&P 500 puts and VIX calls. I did the same in the summer, and the insurance cost me, but I was concerned enough that I did not want to risk watching things unravel yet I did not want to move…


Jan 16, 2020

Interesting analysis, Tim. You obviously have too much time on your hands or else you’re not getting enough sleep! My philosophy has been buy and hold and go to a higher cash position during periods of turmoil, such as we have now, at least politically. The other concern I have is the inability to compete with AI, logarithmic trading that move at nano-seconds to the market. I’ve been enjoying your blogs.

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