Systematic Relative Strength

Relative strength investors will be glad to know that James Picerno’s Capital Spectator blog has an article on the wonders of momentum.  He discusses the momentum “anomaly” and its history briefly:

Momentum is one of the oldest and most persistent anomalies in the financial literature. The tendency of positive or negative returns to persist for a time seems like a ridiculously simple predictor, but it works. There’s an ongoing debate about why it works, but the results in numerous tests speak loud and clear. Unlike many (most?) reported sources of alpha, the market-beating and risk-lowering results linked to momentum strategies appear to be immune to arbitrage.

Informally, it’s fair to say that investors have been exploiting momentum in various forms for as long as humans have been trading assets. Formally, the concept dates to at least 1937, when Alfred Cowles and Herbert Jones reviewed momentum in their paper “Some A Priori Probabilities in Stock Market Action.” In the 21st century, an inquiring reader can easily find hundreds of papers on the subject, most of it published in the wake of Jegadeesh and Titman’s seminal 1993 work: “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency,” which marks the launch of the modern age of momentum research.

I think his observation that momentum (relative strength to us) has been around since humans have been trading assets is spot on.  It’s important to keep that in mind when thinking about why relative strength works—and why it has been immune to arbitrage.  He writes:

Momentum, it seems, is one of the rare risk factors with features that elude so many other strategies: It’s persistent, conceptually straightforward, robust across asset classes, and relatively easy to implement. It’s hardly a silver bullet, but nothing else is either.

The only mystery: Why are we still talking about this factor in glowing terms? We still don’t have a good answer to explain why this anomaly hasn’t been arbitraged away, or why it’s unlikely to meet an untimely demise anytime soon.

Mr. Picerno raises a couple of important points here.  Relative strength does have a lot of attractive features.  The reason it is not a silver bullet is that it underperforms severely from time to time.  Although that is also true of other strategies, I think the periodic underperformance is one of the reasons why the excess returns have not been arbitraged away.

Although he suggests we don’t have a good answer about why momentum works, I’d like to offer my explanation.  I don’t know if it’s a good answer or not, but it’s what I’ve arrived at after years of research and working with relative strength portfolios—not to mention a degree in psychology and a couple of decades of seeing real investors operate in the market laboratory.

• Relative strength straddles both fundamental analysis and behavioral finance.
• High relative strength securities or assets are generally strong because they are undergoing fundamental improvement or are in a sweet spot for fundamentals.  In other words, if oil prices are trending strongly higher, it’s not surprising that certain energy stocks are strong.  That’s to be expected from the fundamentals.  Often there is improvement at the margin, perhaps in revenue growth or operating margin—and that improvement is often underestimated by analysts.  (Research shows that investors are more responsive to changes at the margin than to the absolute level of fundamental factors.  For example, while Apple’s operating margin grew from 2.2% in 2003 to 37.4% in 2012, the stock performed beautifully.  Even though the operating margin is expected to be in the 35% range this year—which is an extremely high level—the stock is getting punished.  Valero’s stock price plummeted when margins went from 10.0% in 2006 to 2.4% in 2009, but has doubled off the low as margins rebounded to 4.8% in 2012.  Apple’s operating margin on an absolute basis is drastically higher than Valero’s, but the delta is going the wrong way.)  High P/E multiples can often be maintained as long as margin improvement continues, and relative strength tends to take advantage of that trend.  Often these trends persist much longer than investors expect.
• From the behavioral finance side, social proof helps reinforce relative strength.  Investors herd and they gravitate toward what is already in motion, and that reinforces the price movement.  They are attracted to the popular and repelled by the unpopular.
• Periodic bouts of underperformance help keep the excess returns of relative strength high.  When momentum goes the wrong way it can be ugly.  Perhaps margins begin to contract and financial results are worse than analysts expect.  The security has been rewarded with a high P/E multiple, which now begins to unwind.  The herd of investors begins to stampede away, just as they piled in when things were going well.  Momentum can be volatile and investors hate volatility.  Stretches of underperformance are psychologically painful and the unwillingness to bear pain (or appropriately manage risk) discourages investors from arbitraging the excess returns away.

In short, I think there are multiple reasons why relative strength works and why it is difficult to arbitrage away the excess returns.  Those reasons are both fundamental and behavioral and I suspect will defy easy categorization.  Judging from my morning newspaper, human nature doesn’t change much.  Until it does, markets are likely to work the same way they always have—and relative strength is likely to continue to be a powerful return factor.