A Momentum Trade With 1Q12 Winners

by: Ploutos

If you are worried that you missed the rally in Sears Holdings (SHLD), Bank of America (BAC), Netflix (NFLX), Whirlpool (WHR), or Priceline (PCLN), academic literature on momentum strategies and my own analysis of the future performance of trailing winners in the S&P 500 (SPY) could provide support for further gains.

The canonical work on momentum strategies in single-name equities was written in 1993 by Narasimhan Jegadeesh and Sheridan Titman. The paper highlighted a strategy that bought stocks that performed well in trailing periods and sold stocks that performed poorly in the past, and demonstrated that this strategy generated significant positive returns over three month to twelve month holding periods over a period stretching from 1965 to 1989. In their analysis, a strategy that selected stocks based on their returns over the past six months, and held them for six months, realized a compounded excess return of 12.01% per year on average. An alpha of 12% per year will make an investor wealthy in a hurry.

Since some market participants believe that market efficiency will correct for these pricing anomalies, I re-examined a momentum strategy that purchases the five stocks that led the S&P 500 in performance over the trailing three months, holding these stocks in an equal-weighted portfolio for the next three months. The quarterly returns of the momentum strategy compared to the quarterly returns of the S&P 500 are tabled below.

The momentum strategy outperformed the market on average by over forty percent per annum. However, the momentum strategy was also a very risky endeavor, producing an annualized standard deviation of the quarterly return streams of 82.6%, over two times the volatility of the broader market over the period and nearly five times the historical volatility of the S&P 500. While risk-adjusting the momentum strategy still produced an outperformance of roughly 35% over the S&P 500, investing in the momentum strategy was not for the faint of heart. The momentum strategy underperformed during the stock market swoon in the back half of 2008, but more than made up for these declines with tremendous outperformance in the subsequent market recovery. The growth in the value of the momentum portfolio is graphed against the cumulative total return of the S&P 500 over the past five years to demonstrate the magnitude of the outperformance.

The data tables below detail the names included in the momentum portfolio historically.

Disclosure: I am long SPY.