Value vs momentum chart of the day

By Felix Salmon
September 10, 2010
Andrew Haldane:

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Chart of the day comes from the Bank of England’s Andrew Haldane:


What you’re seeing here is the result of two different investing strategies. The red line is momentum: every month, you do one of two things. You go long the market when the market rose the previous month; or you go short the market if it fell the previous month. The blue line, by contrast, is value: you use a dividend discount model, and buy the market when it’s cheap, and sell it when it’s expensive.

Here’s the results, as presented by Haldane in his speech to the Oxford China Business Forum, in Beijing:

The speculator’s $1 stake in US equities in 1880 would by 2009 have grown to over $50,000. The fundamentalist’s same $1 stake would have fallen to be worth around 11 cents. Impatience would have trumped patience by a factor of half a million.

Gavyn Davies can’t think of any good reason why there should be any outperformance here, let alone anything of this magnitude. I’m inclined to agree with him: I can think of a couple of things which might be going on, but none of them feel particularly convincing.

Still, both of these strategies involve going both long and short. Stocks generally go up over time, so in general a strategy which goes long more than it goes short is likely to outperform a strategy which goes short more than it goes long. If the dividend discount model has even a modest overinclination towards concluding that stocks are overpriced, it’s going to get crushed: you don’t know pain, in the markets, until you put on a short position and watch the stock you borrowed crawl inexorably upwards.

For real people, long-short strategies are nearly always contraindicated, no matter how profitable they might have been in the past. And this chart only serves to underline that fact: the sensible, fundamentals-based strategy is disastrous, while the crazy crowd-following strategy, which ought not work at all, turns out to be highly profitable. Still, I would have loved to see a third line, showing the results of a simple buy-and-hold strategy. Sometimes the easiest things to do are also the most profitable of all.

Update: Many thanks to Jake, who has come up with a whole series of new charts comparing these numbers to a buy-and-hold strategy. Here’s one:



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A lot of the best value funds tend to have very low annual turnover (10% – 30% of the portfolio). As a result, the 1-month holding period is very unrepresentative of the best value funds actual investing strategies. Probably one of the key reasons is that a value stock may take months or years for the value to be reflected in the actual market price.

Up periods tend to have longer durations than down periods, so there is a very good chance that the model is reflecting this where the upward bubble keeps grinding upwards for longer than it takes to shoot down. Markets tend to overshoot going up and going down, so a strict valuation strategy in this model may be putting shorts on when the market is just starting to go nuts and taking the shorts off and buying while the market is still only half-way down. I don’t think most real-world value investors work quite that way.

However, the momentum funds tend to have much higher annual turnovers, so the 1 month holding time is much more representative of their strategies.

Posted by ErnieD | Report as abusive

Prior writings I’ve seen on momentum strategies usually conclude they can win before costs, but lose after costs

Posted by 3oosion | Report as abusive

I may be misfiring in my calculations here, but I found the dataset at Robert Shiller’s to actually calculate the buy-and-hold strategy.

Using real price return (1290%) and real dividend return (26078%), that’s a 27,368% return, without reinvestment of dividends.

Using a very quick and dirty reinvestment methodology, I calculated a return of 105,651%. Looks like buy and hold wins by double.

Posted by jamesagain | Report as abusive

A quick spreadsheet analysis reveals a nominal annual rate of return of 8.75% for the momentum strategy. That’s probably a bit less than B&H. It’s not clear if transaction costs and reinvested dividends are included in the strategies presented.

Posted by mreide | Report as abusive

Without seeing what a simple buy and hold line would look like, this graph is pretty meaningless. For most of the time period (before SPDRS) trading costs would kill you in the momentum strategy.

Posted by gatorbrit | Report as abusive

Barry Ritholz had a post using Vangaurd’s interactive buy and hold chart (I think its a broad market chart rather than just S&P500): guards-broken-buy-hold-model/

“. . just a tweak here, down 20% to get you out, up 23% to get you back in — voila! Massive out performance”

Looks like it would be even better if you tweaked it to add shorting the market. So I suppose if you were and individual you would have to do this with a discount broker and short ETF’s?

Posted by BottyGuy | Report as abusive

Shiller (2003) finds that the S&P gyrates around the stable trend of his DDM value — so ‘value’ has a net average invested of $0, since it’s short half the time. ‘Momentum’ is long roughly 60% of the time. The chart is cute, but on top of being terrible analysis is fundamentally dishonest. This guy is part of the BoE?

No wonder Sterling is in the tank.

Posted by wcw | Report as abusive

The chart is gross returns. If you net out costs, the effect vanishes.

Posted by 3oosion | Report as abusive

I’m deeply suspicious of any quant model that claims to implement a “value” approach, and a “dividend discount” model only makes sense if you have a solid grasp on whether the dividends are likely to grow, shrink, or evaporate.

The author has proven that you CAN reliably lose money in the stock market if you adopt a thoroughly idiotic system. It is essentially a straw-man argument.

Posted by TFF | Report as abusive

Felix – a more relevant chart would probably be momentum vs mean reversion.

anyway, one reason momentum is so juicy is because of FAT POSITIVE TAILS… most other strategies truncate them – selling far too soon when you get, for example, those 18 year bull market runs… That’s where the bulk of the performance comes from.

Posted by KidDynamite | Report as abusive

Felix, your explanation and analysis is dead on. You put this problem to bed just as soon as you asked the question!

Posted by DanHess | Report as abusive

This was the particularly dubious talk he gave where he praised the Eastern propensity for patience and the Chinese model? One can only assume he hasn’t taken a look at the turnover on the KOSPI futures.

Also I wonder what the drawdown is on the momentum strategy…

Posted by Danny_Black | Report as abusive

Not to get indignant but there’s a lot wrong with this analysis:

1) Value has been academically proven on a multi-year horizon in terms of reversion to the mean. Momentum has been proven on a multi-month basis. Applying value to multi-month entirely misuses the concept.

2) What value investor uses DDM as their sole measurement? Momentum guys really do buy just because it’s going up.

3) Value investors, on the whole, do not short stocks. Stocks can become exponentially overpriced and can only go to zero. They would be much more likely to sit out of the market than short.

Anyways, there’s my backlash :)

Posted by TWSInvestments | Report as abusive

Agreed with TWS… I consider myself pretty much a pure “value” investor (my emotional bias is counter-momentum), yet the stocks I end up with are often described by others as “growth” stocks or sometimes “dividend growth” stocks. I rarely find myself buying anything with a TTM P/E under 12 or a dividend yield over 4% (other than regulated utilities) for the simple reason that companies trading at those valuations usually have a pretty dismal outlook. Building a quant model to describe a sensible value approach is HARD, as the essential question isn’t “how cheap is this stock” but “how cheap is this stock relative to its risk profile and growth prospects”.

Nor would I ever consider using a “value” approach to short the market. I’ve been tempted occasionally to try a long/short pairing of similar stocks, when I think I’ve identified a serious mis-pricing, but even that would be risky. Rather, I stay fully invested at all times, using “value” assessments to select individual stocks within sectors and slant the weighting between sectors.

I’m pretty sure my approach would lag in an extended bull market, but it holds up nicely in a bear market and has been turning a positive return in our present peripatetic trading. My guess is that this portfolio behavior increases my chances of hitting my modest investment goals over a 30 year period, even if it might (or might not?) lag a momentum-based strategy over a 150 year period.

Posted by TFF | Report as abusive

Still, the best strategy is to gather the returns from all fluctuations around known trend of the S&P 500. Teh trend can be foreseen years ahead. We have been demonstrating an excellent prediction of the S&P 500 since March 2009 on Seeking Alpha ( the-s-p-500-in-september-2010-back-on-tr ack ).

Posted by ikitov | Report as abusive

Also, the dividend share of earnings in the S&P 500 dropped sharply over the 20th century, such that dividends ceased to be a useful proxy for earnings. A value investor would presumably have noticed this, and shifted toward a strategy using a PE ratio or Q ratio, rather than the classic DDM.

Posted by rich_c | Report as abusive

Are dividends taken into account ? Value Investing is a lot about dividends whereas momentum is not. And in the long run, dividends are a big share of returns.

Posted by jrmlal | Report as abusive

Why do so many smart people like Haldane‘s study? Confirmation bias, or what?

I don’t think John Templeton or Peter Lynch or Warren Buffett would consider this study a test of the value strategy. What this study shows is that if you ignore the central concept of a strategy and naively employ a tool that is typically used with the strategy, the market will crush you. The “value” in “value investing” doesn’t mean you buy “cheap,” which too often is junk near fair value. It means you establish a “margin of safety” through research, buying a solid company with good long-term growth prospects for much less than it is worth. The rules used in the study don’t do justice to the principle on the long side, and grossly violate the principle on the short side.

If momentum trading outperforms value investing to the extent found in the study, then there would be hoards of people who accumulated more money through momentum trading than Warren Buffett accumulated through value investing. How many such people can you name?

Posted by Bfuruta | Report as abusive

Valuation does not work as a short-term strategy — it is a 2-5 year phenomenon. Momentum is a short-run strategy — it is a

Posted by DavidMerkel | Report as abusive

Felix- charts on EconomPic were updated based on feedback from a reader (I wasn’t properly accounting for dividends).

Posted by Jake103 | Report as abusive

Felix – FYI…posted a follow up to Haldane’s strategy here: 0/re-the-power-of-momentum/

In a nutshell, it’s a dud because Shiller’s S&P 500 price represents the AVERAGE price for the month, not the month-end.

That means it’s not reproducible (and completely falls apart when applied to actual prices).

Just my small contribution to the discussion.


Posted by MarketSci | Report as abusive