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The Momentum Reversal: A Cautionary Tale

Momentum has been a popular factor in portfolio construction for years. A combination of academic research, media hype and human nature lure investors to stocks that are doing well. Over long periods, stocks that outperform often continue to outperform, while stocks that underperform tend to continue underperforming. An important caveat to this phenomenon however, is that in the short-term, momentum factors can be highly volatile.

Applied Finance constantly reviews factor performance as a way to help explain current market conditions. In the first half of 2020, we spent a significant amount of time looking at the Work from Home trade: certain Technology and Healthcare stocks did extraordinarily well during the initial panic of Covid-19. These trends eventually unwound as lockdowns slowed and broad re-openings occurred. Today, we’ll review how this process played out in relation to momentum factors and evolved into the current year.

The tables and charts below depict the top and bottom quintile of several factors within the Russell 1000 from 2012 through July 2021. Rankings and portfolio creation are done on a monthly basis, and performance depicts the average quintile return vs the average return of Russell 1000 stocks (i.e. the spread). For example, the Low quintile (low momentum) bucket return of -0.8% in 2012 means that the average return of stocks in the Low quintile was 0.8% under the average of Russell 1000 companies. The momentum factor is simply performance over a 1-year time frame.

Historically, High momentum stocks have done quite well, with the top quintile outperforming the bottom in many years. In 2020, the High momentum group did significantly well in the early part of the year, while that trend reversed in the second half and into 2021. YTD, we’ve seen the largest reversal in the momentum factor since 2016, with High momentum companies underperforming Low firms by over 15%.

Another popular factor used to judge momentum attributes is Sales Growth. Using 1-year LFY data, we can sort companies into High growth and Low growth buckets (again using a quintile method). While regular momentum did well in early years, Sales Growth as a factor did poorly, until the run-up in 2020. During the early recovery stages of Covid-19, investors scrambled into the fastest growing companies. This year however, those flows have reversed.

While we see certain momentum trends in broad markets, we can especially see these patterns in the Technology sector. Using Applied Finance data, we group companies by their SIC code into a Technology core which comprises a mix of Technology, Communications Services and other names.

2020 saw the strongest momentum market in recent history, with the top quintile outperforming the bottom by 40%. In a massive reversal, 2021 has seen the best performers now underperform the worst by nearly 25%. This can be seen as somewhat of a “dead cat bounce” in the factor world, where the worst performing stocks during Covid then rally on re-opening trends.

Finally, Sales Growth in the Technology space exhibited the largest reversal of factor returns over the past two years. Driven by the mayhem of speculation in the Work from Home space, many high growth Tech names showed phenomenal performance during 2020. A combination of uncertainty, the “Robinhood effect” and online business growth spurred investors to pour money into these companies, regardless of profitability. 2021 has seen the opposite occur so far, with slow growth Tech names outperforming the fastest growers by nearly 20%.

Momentum has a long history as an investment factor. From Richard Dennis in commodities to AQR’s 6 factor model, investors tend to push money into areas that have done well in the past. While long-term performance attributes are clear, shorter term trends can be highly sporadic. The Momentum push in 2020 and then subsequent reversal has shown that and serves as a cautionary tale to investors chasing returns. Applied Finance believes that Momentum and Growth are important features of companies, but only in the context of Wealth Creation and Valuation. We will continue to monitor these factors over the upcoming months to see how the current Momentum reversal plays out and follow up with any new developments.

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Author

  • John Holt, CFA joined Applied Finance in 2014 and is involved in the management of both quantitative strategies and analyst driven strategies.

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