Why Momentum Investing Is Back

by: Nicholas Vardy, CFA

With all four major U.S. stock index averages hitting record highs in recent weeks, momentum is back in the stock market. With banks and small-cap stocks up by double-digit percentages since the presidential election, investors who have been sitting on the sidelines are tempted to jump on the momentum train.

Yet many potential market players resist that temptation. That's because many investors are deeply suspicious of momentum investing. Investors are happy to embrace respectable value investing. After all, analyzing balance sheets, income statements and cash flows takes a lot of formal education and book smarts.

In contrast, investment courses rarely - if ever - include lessons on how to pursue momentum investing. This reality exists, despite plenty of academic research confirming that a disciplined momentum investing strategy handily outperforms strategies, which invest in cheap stocks.

Momentum Investing Explained

The essence of momentum investing is simple. Once markets get going, they will keep going for much longer than most investors expect. Stocks that have performed well in the recent past tend to continue to perform well. Stocks that have done poorly in the last 12 months tend to continue to do poorly.

In practical terms, momentum investing says you should buy high, and sell even higher. This approach is a fly in the ointment of mainstream modern finance as taught in the nation's business schools. You see, the success of momentum investing flies squarely in the face of the efficient market hypothesis (EMH).

EMH asserts that a stock's price reflects all information about it. The idea that the market prices all stocks to perfection is a bedrock assumption of modern financial theory. To their credit, even the fathers of EMH - Eugene Fama and Ken French - recognized the challenge posed by momentum investing:

The premier market anomaly is momentum. Stocks with low returns over the past year tend to have low returns for the next few months, and stocks with high past returns tend to have high future returns. Several studies conducted based on decades of data have confirmed that momentum investing works embarrassingly well.

Traders using momentum strategies, say, buying winners of the last six or 12 months - consistently make more money over time than simply buying cheap stocks. A recent study by hedge fund AQR showed that a momentum strategy gained 8.3% per year from 1927 to 2013, compared with 7.9% for the overall stock market, and a mere 4.7% for value stocks.

A Politically Incorrect Style of Investing

Why does momentum investing make value investors feel so queasy? First, momentum investing has nothing to do with fundamentals. Value investing is about the hard work of analyzing financial statements, screening managements and evaluating business prospects - each of which requires a unique blend of academic knowledge and practical experience.

In contrast, momentum investing is similar to an elaborate game of musical chairs where the players are vying for a seat before the music stops. As a Financial Times columnist put it a few years ago: "It feels wrong that money can be made this way."

Second, momentum investing is about making money, pure and simple. Value investors serve a noble purpose in identifying unrecognized value in the market, thereby helping to make it more efficient. In contrast, momentum investing is downright cynical, disregarding the fundamentals of the underlying asset and only reinforcing the market's inefficiencies with its "me too" investing approach.

Third, momentum investing exploits the irrationality of market players. The smart people who won Nobel Prizes for developing modern financial theory are annoyed by irrationality. In fact, they simply assume it away.

In their model, all market participants are the homo economicus - the perfectly rational actor each of these academics aspires to be. In contrast, momentum investors simply profit from the distortions of the short-term psychology of the stock market.

Challenges of Momentum Investing

For all its proven successes, few investors trade purely on momentum. Momentum investing may be simple. But it's not easy.

First, momentum investing is a high turnover, high-cost strategy. Annual turnover often exceeds 100%. Commissions, spreads and capital gains taxes drag on performance. Momentum investing also takes relentless discipline and hard work to a level few investors can muster consistently.

Second, momentum feels good when you are in the flow. However, that flow can reverse swiftly. Pullbacks in momentum stocks are often more painful than the overall market. Massive drawdowns also can mess with the most robust investor's psychology.

Third, nothing works all the time. Momentum strategies have underperformed the broader market since 1991. Surprisingly, value has fared even worse. If you are of a contrarian bent, this underperformance may be reason enough alone to give momentum investing a shot.

The bottom line?

Modern finance is confused by the statistical success of momentum investing. Simply ignoring investor psychology does not make the momentum anomaly disappear. Humans are not perfectly rational creatures. Nor is human psychology set to change in the near future.

Finally, successful momentum investing also offers the irresistible promise of significant gains over a short period, which all stock market investors crave - whether they admit it or not. That fact alone ensures why momentum investing, the most politically incorrect of investment styles, will continue to thrive.