By Nicholas A. Vardy, CFA
With all four major U.S. stock index averages hitting record highs in recent weeks, momentum is back in the stock market. Banks and small-cap stocks are up by double digits since the presidential election, and investors who have been sitting on the sidelines are tempted to jump on the momentum train.
Yet many potential market players will 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 the how to's of momentum investing. This, despite plenty 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 tend in the last 12 months 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 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 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 the 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.
