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Momentum Factor: What It Is, and Why It Works

Sept. 18, 2023, 8:37 a.m. |Factors |Beginner

Suppose you ask someone who knows nothing about investing to pick stocks. How do you think they'd make the choices? Many of them would Google for websites showing the historical prices of stocks. They would gloss over the financials where terms like 'gross profits' only make them wonder how profits could be unsanitary. They'd pay scant attention to company presentations detailing business lines in impenetrable jargon. No, they'd flip through charts, find a stock with an upward trajectory relative to other stocks and say, "That one! I'd buy that one".

Ball Momentum

Seasoned investors may sneer at the simplicity of such an approach, but those sneering should eat some humble pie. Stocks chosen through this strategy would have outperformed index funds through the past decades. This phenomenon and the associated strategy is called 'momentum.'

There are different flavours of momentum, distinguished by timeframes used for analysis. Academics often use the '12-2' variation, which ranks price changes of stocks from 12 months ago to 1 month ago. This definition omits last month's price change because stocks that performed well in the most recent month tend to do poorly the next month - a separate phenomenon called 'short-term reversal,' and removing this effect improves performance. Short-term reversal, however, is weak or non-existent in larger stocks, so practitioners frequently use the 12-month variation, which ranks stock price changes over the past 12 months with the most recent month kept in. Other variations, such as the 6-month momentum, are less common but are sometimes used to augment strategies that use a 12-month variation.

How funds use these price change rankings differ from fund to fund. Some, like most momentum factor ETFs, tilt their allocation weights toward higher-ranking stocks. Others use the rankings to filter out low-momentum stocks. Such funds may not see momentum as the primary driving force but use it to mitigate the risks of investing in losers.

Momentum is distinct from another price-based factor called 'trend.' We calculate the former in relation to a stock's peers while we analyze the latter in absolute terms. A stock that declined by 10% while the market average crashed by 30% has positive momentum but negative trend. A momentum fund is typically fully invested in the markets at all times, while a trend fund will sometimes move cash to the sidelines.

The effectiveness of momentum strategies have long perplexed academics who believe the markets are "efficient" - i.e. that no one should be able to pick stocks that beat the market consistently. Eugene Fama, the Nobel prize-winner and an outspoken advocate of the efficient market hypothesis, once admitted that "the premier anomaly is momentum." One could perhaps understand if a highly complex strategy produced generous returns. The momentum strategy, however, requires only rudimentary access to data and elementary school-level math to implement.

So why do momentum strategies work, exactly? No one has a definite answer, but there are several popular theories.

One theory posits that investors react slowly to positive news, resulting in gradual price appreciation when a more rational reaction should have been a sudden, one-time jump. The introduction of the iPhone, as we now know, was a seminal event that started Apple down the path of making over $100 billion in profits over the subsequent ten years. From Steve Job's product announcement on Jun 29, 2007, to one year later, Apple's stock price rose from $3.70 per share to $5.16, handily outpacing the US stock market average. But the share-price gains dramatically underestimated, and for many years continued to underestimate, the money the product would bring in for Apple.

Investors' underreaction is rooted in a psychological bias called 'anchoring.' The bias causes investors to imagine a future similar to what they know, and what they know is the past. Apple had recorded sales of $24 billion in 2007. Only the most optimistic investor would have expected Apple's revenues from the iPhone alone to reach $141 billion by 2017. Those with more conservative outlooks adjusted their expectations only gradually, nudging stock prices up at the same speed.

On the other hand, some momentum phenomena may not have their roots in business fundamentals but rather in trading dynamics. Stock prices increase when there are more buyers than sellers, and stocks, as with ordinary products, benefit from marketing and PR. Boring stocks, such as utility stocks, can wait a long time before they're purchased - like an ancient ruin, they need expert investigation to shed light on their value. Other stocks cause more excitement, and this feeling is sometimes sufficient to endow them with momentum.

Marijuana stocks are a good example of this phenomenon. There was a frenzy around these stocks around 2017-2018 as governments announced plans to decriminalize pot. Many new companies entered the stock market, selling hopes of becoming a player in what seemed sure to become a giant industry. Investors heard about them through the media buzz and during everyday conversations centred around decriminalization, prompting many to purchase those stocks. Although those companies have yet to justify their hype with financial results to this day, the chatter around marijuana persisted for a while, kept demand for those stocks elevated and enabled them to exhibit positive momentum until the hype dissipated.

Because momentum is rooted in investor psychology and we expect humans to make trading decisions for the foreseeable future, most quants expect the momentum phenomena to persist. One cause for concern, however, is its overuse.

Imagine a world where everybody only bought stocks with positive momentum. Yesterday's winners would always be tomorrow's winners. But this can introduce severe disconnection between stock prices and business fundamentals. Suppose a stock has negative momentum, so its price falls perennially, but its business consistently produces profits. This stock's price would eventually reach a point where the business becomes unreasonably cheap considering its earnings. For instance, a company with $1 billion in annual profits could have just $2 billion in market cap. On the other hand, an unprofitable stock with positive momentum may continue to get even more expensive. I sometimes wonder if momentum overuse is behind the increasing divergence in P/E ratios in recent years.

I feel that momentum, as with any other quantitative factor, shouldn't be solely relied upon for picking stocks, especially now that every quant in the world is familiar with the research. But it does remain an essential part of my toolkit.

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