With wide expectation that the Fed will raise interest rates this month, it is worth considering how a momentum strategy tends to perform in a rising interest rate environment. Invesco PowerShares addressed this topic in their September 2015 paper Harnessing the Power of Factor Investing. According to their findings, momentum was able generate excess returns in both rising rate and declining rate environments. However, the excess returns were higher in rising rate environments.
Some thoughts on why this pattern may occur:
- By the time rates rise you are typically well off the market bottom and well out of a recession. On average, stocks are at least fairly valued at that point and there aren’t a ton of bargains to be had that are really cheap for obvious reasons. At that point investors look for growth and that is what momentum is good at picking up.
- Late cycle also means fewer stocks participating in the rally, which is also good from a momentum perspective.
- Good momentum stocks usually don’t have to rely on cheap financing (they can generate cash flow organically) so they don’t get crimped like value stocks do when rates rise.
While many seem to fear what affect a rising interest rate environment will have on stocks, it is worth remembering that rising rates have tended to be good for a momentum strategy.
The relative strength strategy is NOT a guarantee. There may be times where all investments and strategies are unfavorable and depreciate in value.