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Momentum Is Dead. Long Live Momentum.© Sound Mind Investing | January 2011
SMI's preferred investing strategy, our Fund Upgrading approach, has provided only a slim advantage over the market the past three years. It's understandable that some readers might question whether to continue an investing strategy that requires some effort on their part (compared to our passive Just-the-Basics strategy), yet hasn't produced a really good year since 2007. Has something changed in the markets that undermines Upgrading's long history of effectiveness? It's a fair question. We are continually conducting our own internal research with respect to this issue, and we read with interest related research done by others. Along these lines, a recent study from Jeremy Grantham's highly regarded investment company, GMO, caught our eye. The research report is titled Momentum — A Contrarian Case for Following the Herd (PDF). In it, author Tom Hancock relates the findings of research GMO has done on the performance of large-company stocks (not funds) from 1927-2009. The study reports that over the 80-plus years studied, there was clear "persistence" in the short-term performance of the stocks studied. Persistence is the term they use to describe the tendency of a stock's recent relative investment superiority to continue. In other words, do top-performers continue to be top-performers, and if so, for how long? Here's what they found. When the top 25% of large-company stocks, performance-wise, were bought and held, they tended to underperform their peer group initially. But by the 6th-15th months, the top-quartile holdings outperformed their peer group by an annualized rate of over 3%. That's a highly significant level of outperformance when compounded over decades. And it's held true for more than 80 years! So it's safe to conclude that the momentum effect isn't a new thing. It's been working for a very long time. Interestingly though, the degree to which the momentum strategy outperformed the overall market was the weakest during the past decade of any of the eight decades in the study. The 1940s and 1980s were also relatively weak periods. Still, even during these decades, returns were nevertheless boosted (relative to market peers) by utilizing this momentum approach. The fact that momentum has gone through similar periods of lower performance, only to come back stronger than ever, should be reassuring to any investor wondering whether pursuing a momentum strategy in the future is a wise move. The bulk of the GMO report is actually spent rebutting the four primary criticisms of momentum investing that are commonly heard today. The full report will be reassuring reading for anyone harboring these types of doubts. While there are certainly differences between the stock momentum this white paper is specifically addressing and SMI's brand of Fund Upgrading, there are also similarities. Talk of "top quartiles" and focusing on the "performance of the most recent year" should sound familiar — it's right out of the SMI Upgrading playbook. Furthermore, the report confirms a number of points that long-time SMI Upgraders will find familiar. For example, it finds that momentum typically fares worst at market turning points. We have written about this often, noting that as a trend-following system, Upgrading's weakness is exposed when the dominant trend shifts and our portfolios need to be changed accordingly. However, the study also notes that while momentum's performance typically lags in the six months following market turning points, it quickly rebounds to its typically higher gains once those six months have passed. This is consistent with our experience: Upgrading usually takes several months to turn over its holdings, then goes right back to beating the market. Summarizing the report, we've just concluded the worst decade for momentum investing in the past 80 years. Yet the GMO report concludes nothing has fundamentally changed that would prevent a momentum strategy from performing as well in the future as it has in the past. The report also points out the tendency for momentum to experience its best results in the years immediately following periods of poor relative performance. Given that Fund Upgrading nevertheless produced annualized gains of 8.4% per year during this "worst decade on record," it seems that SMI readers have every reason to be optimistic — and every reason to keep Upgrading. 
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