There’s a big article on momentum in stock markets in The Economist. Momentum is otherwise known by its original name, relative strength, if you are a stock market historian. Like all articles that actually examine relative strength as a return factor, it results in nearly unqualified gushing:
Since the 1980s academic studies have repeatedly shown that, on average, shares that have performed well in the recent past continue to do so for some time. Longer-term studies have confirmed that this “momentum” effect has been observable for much of the past century. Nor is the phenomenon confined to the stockmarket. Commodity prices and currencies are remarkably persistent, rising or falling for long periods.
Actually, stock market traders noticed this tendency by 1900, so it must have been apparent even in the 1800s. And the first computerized test that I know of dates to the late 1960s, even earlier than the mid-1980s mentioned in the article.
The momentum effect drives a juggernaut through one of the tenets of finance theory, the efficient-market hypothesis. In its strongest form this states that past price movements should give no useful information about the future. Investors should have no logical reason to have preferred the winners of 2009 to the losers; both should be fairly priced already.
Markets do throw up occasional anomalies—for instance, the outperformance of shares in January or their poor performance in the summer months—that may be too small or unreliable to exploit. But the momentum effect is huge.
I’ve underlined my favorite parts. The article goes on to cite a study done on the British market from 1900 by chaps at the London Business School. Not surprisingly, buying the relative strength leaders was tremendous, earning more than 10% a year above the return on the laggards. You can see the magnitude of the effect in the chart below. $1 turned into $49 buying the laggards, but turned into $2.3 million buying the relative strength leaders. (They used British pounds, but the unit equivalency is the same.) As they say, the momentum effect is huge.
Source: The Economist
The article points out one other thing that I believe is very, very important.
Even the high priests of efficient-market theory have acknowledged the momentum effect.
This is true: even academics have been forced to acknowledge the power of relative strength as a return factor. It’s impossible not to; it’s in the data. Since there is really no way to deny it, even hard-core efficient market types have admitted its existence. The part that always makes me scratch my head is that they follow up their admission by telling investors it’s impossible to outperform and that they should just buy index funds!
Is relative strength magic? No. Does it work all of the time? No. But its power is undeniable, which is why our investment process rests on systematic application of relative strength as a return factor. We think this gives us an excellent chance of outperformance across equity markets and global asset classes over time.
