The Trend Really is Your Friend (Sort Of)
The Trend Really is Your Friend (Sort Of)
I think I have spent enough time talking about the momentum statistical factor. Now it’s time to break down what it is and why the ‘trend can be your friend’, as well as your absolute nightmare.
Efficient Markets & Statistical Factors
As outlined earlier, in 1993 economists Narasimhan Jegadeesh and Sheridan Titman, described the tendency for stocks (and asset prices) that have performed well to continue to perform well, while the inverse tends true for underperformers (though nothing is forever). They identified a phenomenon that anecdotally was well known to traders and market participants. In applying statistical techniques against asset prices, they were able to provide evidence to support this phenomenon, identifying it as one of the five main statistical factors that help explain market pricing anomalies that appear to counter the Efficient Markets Hypothesis. These are Value, Quality, Low Volatility, Momentum and Carry.
For those who believe in even the weak form of the original Efficient Markets Hypothesis, the idea that statistical anomalies exist that drive higher-than-expected returns is hard to wrap one’s head around.
But there are a few reasons why momentum tends to persist across time and asset classes, why it can lead to outperformance, and crucially, how its downsides can reinforce these facts. Let’s explore more.
Momentum Cuts Both Ways
Anyone who learned the hard way about the existence of momentum (by, say, short-selling high momentum stocks like Tesla in 2018 as yours truly did), is well aware of one reason why momentum can be such a persistent phenomenon: it’s difficult to arbitrage.
Momentum presents a material career and financial livelihood risk to market participants who bet against it, or who don’t participate in it. The former is obvious: short-selling a high momentum stock can quickly lead to insolvency, as short-selling tends to involve unlimited downside risk. Conversely, not hedging a high-momentum and highly volatile input can put businesses with thin operating margins at risk--as evidenced by the tendency for oil refiners and physical commodity traders to use futures to protect their margins.
The risk to financial livelihood, however, can be seen as more behavioural. We all know about FOMO (fear of missing out); as Gen Z would say, it’s “FR-FR” (for real, for real). When it comes to asset prices, and especially equities, recency bias and herding behaviour are the professional investors’ equivalents. The reality is that short term investment performance is the yardstick by which most professional market participants are measured. Rising shares tend to attract more flows, funds, and ultimately more income, so there is an embedded incentive to chase hot themes--which then tend to become self-fulfilling as more assets flow into those themes and precipitate further asset value increases.
This behavioural and market structure-driven feedback loop goes a long way in explaining both the power and persistence of momentum-driven price action Although there are some significant downsides to trying to harness momentum (as momentum can eventually slow down, stop, or even reverse course), that also, in part, explains its persistence.
Momentum – Outperformance at a Cost
Like trends in fashion, culture or anywhere else, momentum is often transitory. More accurately, what is hot now is not likely to be what’s hot for the long-term. Case in point is how, since 2015, we’ve seen investment themes jump from cannabis to crypto and now to AI. Meanwhile, some of those seemingly successful businesses have gone into bankruptcy.
While academic research has found that momentum-focused investment can contribute to monthly outperformance that is 1.75% higher than expected (when controlling for the Fama and French factors in the Efficient Markets Hypothesis), this style of investing is also notorious for the intensity of its crashes s momentum suddenly switches direction. These are crashes which often scare investors off and likely lead to the long-term persistence of the phenomenon.
The fact that momentum leads to improved risk-adjusted performance--even in light of its higher volatility-- is likely cold comfort. For example, momentum-focused investing would cost approximately 73.42% of a US-based equity portfolio over the course of three months in 2009. That sort of decline would be unbearable for most market participants.
Broader Implications
While we can see how FOMO influences our behaviour in day-to-day life, it is also important to understand that a similar phenomenon explains much of the underlying price action in stocks, interest rates, commodities, and especially foreign exchange.
Momentum is powerful: sometimes persistent, and more often volatile. Its influence on price action in financial markets has a material impact for the financial, and physical, well-being of investors, lenders, businesses and individuals.
Knowing and understanding that influence can help protect against a lot of pain.
Read the previous article in the series: Momentum, Efficient Market Hypothesis & Factor Investing
Read the next article in the series: Momentum and Behavioural Finance
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DISCLAIMER: Opinions expressed in this article are those of the author. This article is for informational purposes only and does not constitute advice. Hedging products involve trade-offs, risks, and costs, and results may vary. Before making any decisions, consult an independent advisor not affiliated with Corpay to ensure that the solutions discussed are suitable for your business needs. A comprehensive under-standing of the complexities, benefits, and drawbacks of each hedging product is essential.
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