Value vs momentum chart of the day

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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