Momentum Environments

How consistent are Momentum returns?  This is among the most frequently asked questions about Momentum (and about any investment strategy for that matter).  One way to answer this question is to look at the following table from a white paper published by RBC Capital Markets.  According to their research, Momentum outperformed the S&P 500 in every decade since the 1930’s.  Yes, the margin of outperformance was larger in some decades than others, but Momentum outperformed in each.  You will notice from the table that this was not true of Value or Growth, which both experienced decades of underperformance.

Ken French

However, that is certainly not to say that Momentum outperforms every year.  I do find it entertaining that many critics of active management use the failure of active strategies to outperform every year as an argument against active management.  It is reasonable to expect the sun to rise each morning.  It is reasonable to expect your mother to love you.  But, it is incredibly irrational to believe that an active strategy should outperform every year!

The environments when Momentum tends to perform best is when trends are most stable.  In environments with major changes in leadership, Momentum tends to underperform.  One way to visualize these environments is by looking at our Relative Strength Spread.  This RS Spread takes a universe of U.S. mid and large cap stocks (S&P 900) and ranks them by their relative strength.  We divide the top quartile of the ranks by the bottom quartile to see when the leaders are outperforming the laggards.  A chart of the RS Spread over the last 3 years is shown below:

spread_3

A couple observations:

  • The RS leaders underperformed the latter part of 2012 and some of the first part of 2013, but the majority of 2013 was spent with a steady rising RS Spread
  • The RS leaders had a pullback in the spring of 2014, but then stabilized and saw sharp improvement towards the end of 2014
  • The last couple months have been fairly choppy for the RS Spread, but in recent weeks the RS Spread has moved higher and is on the cusp of moving back above its 50 day moving average

Here is that same chart over the past 25 years:

RS Spread_lt

Some observations:

  • RS leaders have outperformed the RS laggards over time, but the RS Spread has certainly not always been smooth
  • The 1990’s had a relatively stable rising RS Spread with a huge move higher in the late 1990’s during the Tech boom
  • The two biggest laggard rallies occurred toward the end of major bear markets and in the first leg of new major bull markets (late 2002-early 2004 and in much of 2009)
  • The RS Spread has been relatively flat from late 2009 through late 2014

It is important to note that the RS Spread tells you nothing about absolute returns.  The absolute returns of a high relative strength strategy could be positive, flat, or negative in a rising, flat, or falling spread.  All it is telling you is how the RS leaders are performing compared to the RS laggards.  Given the relatively flat RS Spread for much of the past 5 years, I would not be surprised at all to see a strong rising RS Spread over the next 5 years, which could bode very well for RS strategies.

We happen to believe that Momentum is the most robust factor available and that it deserves a meaningful place in investor’s portfolios.  I believe that investors would be well served to have reasonable expectations about the type of returns and frequency of outperformance likely to be achieved by Momentum strategies over time.  If they do, they are more likely to correctly position it in a portfolio and to reap the rewards that we believe will accrue to long-term investors in Momentum strategies.

A relative strength or Momentum strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.

7 Responses to Momentum Environments

  1. […] The environment for momentum changes over time. (systematicrelativestrength) […]

  2. Sean says:

    Great article. We’re going to share it during our Saturday $STUDY Session this weekend. Do you have an account on StockTwits or twitter? If so, what is your handle so that we can give you proper attribution and people can engage with you with questions about this post.

    Thanks,
    Sean

  3. […] Momentum Environments [Systematic Relative Strength] How consistent are Momentum returns? This is among the most frequently asked questions about Momentum (and about any investment strategy for that matter). One way to answer this question is to look at the following table from a white paper published by RBC Capital Markets. According to their research, Momentum outperformed the S&P 500 in every decade since the 1930?s. Yes, the margi […]

  4. Andy Hyer says:

    Thanks, Sean! My Twitter handle is @andyhyer

  5. Joe says:

    I love momentum! So easy to exploit and so consistent. What better can you ask for?

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  7. David Aronson says:

    the graphs, terminology and concept appear to come directly from the book the Janus Factor by Gary Anderson. If this was indeed the source – perhaps it is mere coincidence, though this strains credibility – proper attribution to Mr. Anderson is in order.