Can Momentum Be Arbitraged Away?

Will momentum “work” in the future just because it did in the past?  Or, is momentum susceptible to having its returns arbitraged away?  Valid question, and one that comes up regularly.

First, just a quick review of how momentum has performed in the past.  There are a number of white papers on this topic, but results of a white paper by RBC Capital Markets are summarized below:

exhibit 1

Over this period of time, momentum outperformed in every single decade.  It also outperformed the S&P 500 by 3.7% annually over the test period.  This is just an academic formulation of momentum and there are other formulations that may be better or worse, but the conclusion is pretty clear: momentum is a very robust return factor.

I think there are two key reasons why momentum returns have not been arbitraged away up to this point and why they are unlikely to be arbitraged away in the future.

First, as long as there is momentum in the underlying fundamentals of companies, there will be price momentum in stocks.

Consider, the strong momentum of revenue of Microsoft (MSFT) in the 1990’s.  I only had revenue data going back to mid-1994, but the explosive growth is very clear.

msft

Source: FactSet, June 1994 – December 1999, Trailing 12 month revenue for each quarter

Just as there was momentum in the underlying fundamentals of the company, there was also strong price momentum in the stock during the 1990’s.  In fact, MSFT outperformed the S&P 500 nine out of ten years in the 1990’s.

Also, consider the revenue growth of Apple Computer since 2000:

aapl

Source: FactSet, December 1999 – June 2014, Trailing 12 month revenue for each quarter

Again, there was tremendous momentum in the underlying fundamentals of the company and there was also strong price momentum in the stock.  AAPL has outperformed the S&P 500 every year since 2000, except for three.

In a capitalistic economy, I suspect that there will always be those companies that break out from the pack and are able to experience dramatic growth.

Second, there is a behavioral explanation for momentum that I don’t believe is likely to go away.  This is summarized by Andrew Ang in his book Asset Management: A Systematic Approach to Factor Investing.

In the main behavioral theories, momentum arises because of the biased way that investors interpret or act on information.  Suppose good news on a stock comes out.  Momentum can be generated in two ways.  First, investors could have delayed overreaction to this news, causing the price to persistently drift upward.  Second, investors could underreact to the news.  The price initially goes up, but it does not go up as much as it should have to fully reflect how good the news actually was.

This behavioral explanation is in direct conflict with the Efficient Markets Hypothesis which states that prices immediately reflect any good news.  As Ang points out, rather than investors immediately reacting the news, there tends to be a delayed response, a cascading effect, that creates price momentum in the stock as more and more investors act on the good fundamental news from the company.

So yes, I think it is possible for momentum returns to be arbitraged away, but I just don’t think it is likely.  That is a tall task for momentum in underlying companies to cease to exist and for investors to overcome behavioral tendencies that have been in place for a very long time.

Past performance is not indicative of future results.  Potential for profits is accompanied by possibility of loss.  These examples are presented for illustrative purposes only and do not represent a past recommendation.  A momentum strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.  Dorsey Wright currently owns AAPL.  

12 Responses to Can Momentum Be Arbitraged Away?

  1. […] Can momentum be arbitraged away?  (Systematic Relative Strength) […]

  2. Doug says:

    “First, as long as there is momentum in the underlying fundamentals of companies, there will be price momentum in stocks.”

    This statement is not true. Yes there might always be breakout stocks like Apple or Microsoft, but if the broad market recognizes them when they start breaking out and prices them accordingly then there’s no return premium left.

  3. Andy Hyer says:

    Doug,

    Why didn’t the market recognize Apple’s full potential 15 years ago and then price it accordingly? If it would have there would have been no price momentum in the stock…yet there has been tremendous price momentum in the stock. Seems obvious to me that without a crystal ball the idea that anyone can recognize how the future is going to unfold is unrealistic. I maintain that as long as there is momentum in the fundamentals of companies there will be price momentum as well.

    Andy

  4. Alex says:

    Hindsight works!

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  11. […] strong relative strength it signifies outperformance. Relative strength is also referred to as the momentum factor. One way to interpret relative strength is via the point and figure chart. Our friends at Dorsey […]