Opinion

James Saft

Tough times for momentum investing

October 27, 2011

James Saft is a Reuters columnist. The opinions expressed are his own.

It has been a tough few weeks for momentum investors.

One time darlings like Amazon, Netflix and Green Mountain Coffee Roasters have taken serious tumbles, dealing losses.

Meanwhile, the financial industry, the sector which arguably hasn’t produced positive returns since the 1980s, are on a bit of a tear, bolstered by the latest European rescue and some reassuring U.S. economic data.

There are several intriguing reasons to believe that momentum investing has seen its best days. Momentum investing, beloved by day traders and some hedge funds, is the strategy of riding hot stocks higher while selling laggards.

While the tactic itself is probably as old as the stock market, momentum investing attracted increasing interest in the 1970s and 1980s, culminating in a number of academic studies, which seemed to show that it added value.

Those former go-go stocks are on the retreat for a variety of reasons.

Amazon warned Tuesday that it could slide into the red in the fourth quarter due to heavy spending on medium-term development projects. Amazon shares fell more than 10 percent that day. Even after a rally on Thursday, its stock remains more than 20 percent down from October peaks.

Netflix famously misjudged its customers willingness to accept price hikes and its shares are now more than 35 percent down from its summer high.

Green Mountain Coffee has lost about a third of its value since hedge fund manager David Einhorn announced he was shorting the stock and raised concerns about its accounting practices.

There is more of a coherent theme when it comes to the banks. The KBW bank share index, which fell more than 30 percent year-to-date through Oct. 1, is up more than 20 percent since then. Fears of a round of financial contagion have eased as euro zone officials appeared to get to grips with their debt crisis, and many economists have reduced their odds of a U.S. recession.

All of that is positive for bank earnings, and, frankly, for their ability to remain as going concerns.

So, some momentum investors will have had their fingers burnt, but so what? Surely stock markets go through periodic transitions in which hot stocks go cold and vice versa.

All true, but some recent research indicates that something more fundamental may have changed. And, in fact, the conditions that made momentum investing successful may be long gone.

HEDGE FUNDS AND MARKET EFFICIENCY

Debarati Bhattacharya, Raman Kumar and Gokhan Sonaer, all of Virginia Tech, looked at 44 years of momentum returns up to 2009 and found something startling: momentum returns went missing sometime in the late 1990s.

While you could generate excess returns of more than 0.75 percent a month following momentum strategies between 1965 and 1998 — a really fantastic result — since then that alpha has disappeared. It’s no longer a winning way to beat the market.

To understand why you have to recognize that momentum investment is essentially a behavioral phenomenon, not a fundamental one. Anyone who has ever watched a herd of wildebeests react to a lion should understand why. The wildebeests flee as a group not because they’ve all seen the lion, but because the ones who did not see the predator know how to interpret the reactions of the ones who did.

That sort of instinctive reaction carries over to the greed or fear that news causes among investors. Good news brings its own upward momentum as people pile in, and the reverse is true for bad news.

A run of good or bad developments can take on a weight of its own as trend followers join the party. Pretty soon you are looking at Apple, or perhaps Bear Stearns.

The authors of the study suggest that the growth of hedge funds may be behind the death of momentum. Hedge funds have learned to exploit over and under-reactions to momentum.

Now, having become big enough and quick enough, hedge funds have in essence eaten the fields bare. They eat volatility, and have perhaps improved market efficiency to the stage where the low hanging fruit that was momentum investing is all gone.

Clearly, there were still manias, bubbles and overshoots in the past decade: just look at subprime or European government bonds. That, at least on the surface, would imply that buying what is hot and selling what is not should have some remaining potential. But that would be done as a tactic rather than as a strategy.

Free lunches sometimes exist, but they don’t persist forever. Investors, and hedge fund managers, are going to have to work a bit harder for their supper.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

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