Over the summer, with the debt ceiling impasse in full swing, our firm received lots of questions from concerned clients about how the prospects of a downgrade or a default of U.S. Treasury debt would affect the financial markets and their portfolios. Among the regular questions asked by clients was this two-parter, “Why are the markets not reacting to a potentially catastrophic event? Am I the only one freaking out about this?”
The clients who asked this made a good point. Up until a week before the August 2 debt ceiling deadline, the markets were relatively calm. On July 25, the Dow Jones Industrial Average sat just 1.7% below its 2011 high. Implied volatility on the S&P 500 Index was in the middle of its range for the year. And the yield on the 10-year Treasury note sat just ten basis points above its 2011 low of 2.9%. If an impending financial crisis involving the default or downgrade of U.S. government bonds was just a week out, the market certainly was not acting like it.
As investors know, financial markets typically react by pricing in events well in advance, and the August 2 deadline to raise the debt ceiling was announced by Treasury Secretary Timothy Geithner on May 2 while the U.S. officially hit its debt ceiling two weeks later. So, there was plenty of time for the market to “react.” This lack of market reaction appeared strange to many of our clients because they were very concerned about their portfolios–everyone they spoke to seemed very concerned about their portfolios, and the financial media told them all that they should be very concerned about their portfolios. Yet, despite this apparent widespread concern, there was no meaningful reaction from the market. How could this be?
Of all the questions we received about the debt ceiling issue, the one above was my personal favorite. First, it was an excellent question, and it showed that our clients were closely paying attention to market action and thinking critically about it. But mainly, it provided me the opportunity for a teaching moment about momentum investing, our core investment strategy since 1991. Even for some of our most tenured clients, I find it important to periodically remind them of the core principles of our strategy and why it works.
At its simplest, momentum can be defined as the persistence of winning and losing investments. Strong performing investments tend to continue to perform well for a period of time while weak performing investments tend to continue to underperform for a period of time. It is a phenomenon in the financial markets that is well-documented through hundreds of academic studies, yet largely unknown and overlooked by the general investing public. These studies show the presence of momentum in various asset markets—stocks (both foreign and domestic), bonds, commodities, and currencies—and confirm that it has existed in individual stocks as far back as the late 1800s.
By that standard, we are relative newcomers to the discipline of momentum investing, but we have been practicing it now for over 20 years. Our momentum strategy, ACTIVE PORTFOLIO ENHANCEMENT®, uses no-load mutual funds and exchange-traded funds (ETFs) to invest in broad asset classes rather than individual securities. Our goal is to find the industries, sectors, investment styles, market caps, countries, and geographic regions with the best momentum. What we have found over the last 20 years is that momentum in the financial markets is indeed real.
The three graphs below are what we typically show new clients when educating them about the presence of momentum in financial markets. The graphs plot the relative performance of foreign versus domestic stocks, small versus large cap stocks, and growth versus value stocks in each calendar year for which data is available. The bar points either up or down in each year to signify the relative outperformance of one asset class versus the other. A flat bar means both asset classes had similar returns (i.e. no outperformance) in that given year.
As you can see on the first graph, foreign stocks tend to perform well at the expense of domestic stocks and vice versa (i.e. there are lots of tall bars indicating a large degree of outperformance in a calendar year). While that is important to understand, the most crucial piece of knowledge to take away from these graphs is that the relative outperformance of foreign versus domestic stocks (and vice versa) tends to last for years at a time (i.e. the bars tend to group together). From 1970 to 2010, there were five instances in which foreign stocks led domestic stocks or vice versa for a period of at least four consecutive years. In other words, what has been working tends to continue to work for an extended period of time, not just for months but for years. The same phenomenon can be seen in the small-cap versus large-cap and growth versus value graphs.
We find that momentum is not intuitive for investors—both individual and professional—because it requires an admission that one does not know what the future holds. In an industry in which forecasting and prognostication are prominent, we rely on a decidedly agnostic system in which we let the market form our opinions and allocation. We may have a particular view of the world, but ultimately, our allocation relies on what the market is telling us through its performance trends—its momentum. Whether or not we have a clear understanding or a good “story” as to why domestic stocks are outperforming foreign stocks, we follow the trend because we understand the power of momentum in financial markets.
This takes us back to our clients’ confusion about the lack of volatility in the financial markets leading up to the August 2 debt ceiling deadline. They could not reconcile the fact that the market was not reacting in the face of the seemingly catastrophic consequences of a potential default on U.S. Treasury bonds, which form the basis of our financial system. Perhaps the markets were suffering from a Nero complex, but that is not how financial markets typically behave. If anything, they overreact to news. In this case, all was quiet (as illustrated by the charts above) one week before an event that many investors feared would trigger a financial collapse.
By not reacting, the market was expressing an opinion—one very different than many investors and the financial media had. The market was calm, cool, and collected, which suggested that it believed that a deal would be reached by Republicans and Democrats in Congress prior to the deadline, thereby avoiding any potential of a missed principal or interest payment and the possibility of default. Granted, volatility picked up in the week leading into the debt ceiling deadline and in the weeks after the deal was struck, but that was caused more by poor economic data that reinforced the idea of a slowing economy and concerns about European sovereign debt. As for the debt ceiling issue, the market’s opinion was clear—a deal would be struck in time to make default, the worst of all possible outcomes, a remote scenario. And, the market turned out to be right, as it often is.
It may come as a surprise to some that the market has an opinion, but the market is an amalgamation of the individual opinions of all of its participants (i.e. us investors). Each buy and sell decision we make incorporates our individual opinions about a specific company, the economy, interest rates, inflation, etc. Combine all those opinions (i.e. trades), and we have a consensus opinion of all market participants, which inherently is what the market is as a whole. What may be more surprising is the fact that that consensus opinion is actually quite accurate and one that you should consult as an investor, at least more often than your stock-picking brother-in-law.
In his book, The Wisdom of Crowds, author James Surowiecki explores how the collective wisdom of groups often proves more prescient than any one individual among that group, even if that individual could be considered an expert in the subject at hand. His book, which by the way is a very interesting read, opens with the story of British scientist Francis Galton attending a local fair in 1906 England where he encountered a weight-judging competition. For a price of six pence, anyone attending the fair could guess the post-slaughter weight of an ox, and those with the most accurate guesses would win prizes. 800 fairgoers tried their luck. As Galton later described in the scientific journal, Nature, “Many non-experts competed, like those clerks and others who have no expert knowledge of horses, but who bet on races, guided by newspapers, friends, and their own fancies.” Now that sounds like my stock-picking brother-in-law.
When the contest was over, Galton, being the scientist that he was, borrowed the entry tickets and analyzed the data. He found that the average guess of the crowd was 1,197 pounds, which was just one pound below the ox’s actual weight after it was slaughtered and butchered. The crowd’s consensus opinion was nearly perfect.
Because you are reading this, I know you are an investor (or my mother), so I know exactly what you are thinking. Would this be the same “crowd” who bid up Pets.com to a billion dollar market capitalization in early 2000 only to watch it fall into bankruptcy just nine months later? No, in fact, it isn’t, and Surowiecki makes the point in his book that not all crowds are wise, providing specific criteria that differentiates wise crowds from foolish ones:
- Diversity – members of the crowd must be sufficiently different
- Independence – no groupthink or herd mentality; everyone thinks for themselves
- Decentralization – bottom-up decision making; each individual brings his/her unique and specialized knowledge to the group
- Aggregation – the opinions of the many individuals must be able to be collected and measured as a whole
The crowd at the English fair met these four criteria. Galton, himself, described them as a diverse group of people. They were independent and decentralized in their guessing as they were competing as individuals for prizes; it would have been poor strategy to consult the competition. And Galton provided the aggregation via his post-contest study. Meanwhile, buyers of Pets.com stock clearly fail on the measure of independence as there was a strong element of herd mentality with buyers of dotcom stocks during the internet bubble. No one bought Pets.com because they thought it was a solid company ($619,000 in revenue and $11.8 million in advertising expense in its first fiscal year); everyone bought it because everyone else was buying internet stocks and making lots of money (for a time).
Outside of manic bubbles or panic-induced market crashes, the financial markets tend to typically meet Surowiecki’s four criteria that make a wise crowd. It is a global market with a group of diverse participants—men, women, rich, middle-class, professional, amateur, bullish, bearish. Trading decisions are made independently of one another (assuming CNBC is turned off). Thanks to electronic trading, the financial markets are decentralized as anyone with an internet connection can participate without interference or human contact. And clearly, the market itself is the great aggregator of individual opinions via the movement of prices, rates, and currencies.
By listening to the market, we are admitting that the market is smarter than we are, which it typically is. This is why so many professional investors fail to beat the market over time; they fail to understand the lesson that Francis Galton learned in 1906 and that James Surowiecki succinctly sums up in The Wisdom of Crowds: “The idea of the wisdom of crowds is not that a group will always give you the right answer but that on average it will consistently come up with a better answer than any individual could provide.”
When we present our investment strategy to institutions like endowments and 401(k) plans, we face a tough line of questioning. After all, we are typically interviewed by boards comprised of members who are professionals themselves, often professionals in our own industry. Additionally, we are often the smallest company under consideration for the management of their assets. One of the more frequent questions we are asked in this situation is, “How do you compete with the big brokers and investment banks given their thousands of analysts and immense research capabilities?” Our response is simple and always the same: “We listen to the market.”
While a big brokerage house undoubtedly has unmatchable “research capability,” they are centralized organizations. As we well know, there are conflicts of interest and bureaucracy in large financial institutions. Analysts cannot just say what they think about any company, especially if that company is an investment banking client. Their opinions are influenced by their own organizations, which is why only a small percentage of companies are rated as sells by sell-side analysts. Additionally, their research is typically conducted by analysts and economists, hardly a diverse crowd. It is completely counterintuitive, but Goldman Sachs would be better served by adding butchers, bakers, and candlestick makers to its research department.
Meanwhile, we listen strictly to the market, which benefits from diversity of opinion, independence, and decentralization. By following the market’s momentum, we are tipped off as to where it is headed. Strong relative performance is not just a random walk as the proponents of the market efficiency theory suggest; rather, it is valuable communication—the consensus opinion of a wise crowd. You may not understand why, for example, biotech stocks are performing well, but you don’t have to. All you have to understand is that a very reliable source is suggesting that you should increase your exposure to that industry. If you would buy a stock based on your brother-in-law’s tip, certainly you can start taking tips from a much wiser party.
As I began outlining this article in early August, the market endured a tough day. In fact, it was going through a tough week. The Dow Jones Industrial Average dropped by over 500 points on August 4, and at its worst in early August, it was off by 15% since everything appeared calm a week ahead of the debt ceiling deadline on July 25. Given that type of sharp pullback and volatility, how did we read the market’s momentum? Was the market trying to signal imminent danger in terms of a bear market or double dip recession? Was it time to sell stocks for more defensive investments?
This is where gauging the market’s opinion via momentum becomes a bit nuanced. As a momentum investor, it is important to realize that the crowd is not always wise as Surowiecki points out. Just as crowds fail within the context of a financial bubble so too do they fail in market crashes. As with a bubble, in market crashes, independent decision making—one of the four criteria required for a wise crowd—goes out the window. Investors sell not because they are expressing an opinion on a particular stock or the market in general, but simply because others are selling, and the market as a whole is declining. One investor sells because another investor sells, and then more investors sell as a result of that selling. The result is a cascade of selling that causes the market to fall precipitously. In short, investors react to what other investors are doing, and independent decision making is lost. The crowd is no longer wise.
In 20-plus years of momentum investing, we have learned two tools for dealing with the unwise crowd that the market can occasionally become. The first is to smooth out the volatility in the market by looking at momentum over various periods. While we track very short-term momentum in terms of days and weeks, we are most concerned with momentum over monthly periods up to as much as a year. We include the one-year momentum figure in our analysis because it helps to filter out some of the noise that affects market action in shorter-term periods, which ultimately helps us to identify and stay with trends with “legs”— the ones that can last multiple years at a time. Without a tool for smoothing out day-to-day volatility, 500-point down days or short-term corrections can take us out of these long-term trends prematurely.
The second tool is to overlay a valuation analysis on top of the momentum strategy. By looking at the valuation of the market and specific sectors or countries, we can gauge whether that particular area of the market has become overbought or oversold. Consider these two historical examples as illustrations:
In late 1999 and early 2000, it was apparent that technology stocks had become significantly overvalued. If we had listened to the momentum of the market, we would have been fully invested in highly speculative internet stocks that were ripe for a crash. Instead, because we saw that valuations for tech stocks were historically high, we understood that we were likely in a bubble and that the market’s opinion was unsound and would likely lead us astray. As a result, we sold out of tech stocks at the first sign of a reversal in momentum, which occurred in late 2000 and prior to the worst of their decline.
In March 2009 at the bottom of the last bear market, of the 923 funds we tracked at the time, every fund but two possessed negative momentum given the six-month-long crash that began when Lehman Brothers failed in the previous September. Of the two funds with positive momentum, one invested in gold and silver futures and the other was a long-short fund that hedged. Every long-only equity fund had very negative momentum, yet we stuck with equity funds because our valuation analysis showed that stocks were as cheap as they had been in nearly 30 years. The market was in a free fall, and investors were selling without concern to fundamentals. They were simply selling because everyone else was, so the crowd during that time was not wise. As a result, we overruled momentum with valuation and began to enjoy the recovery in equities that began shortly thereafter.
Momentum is a powerful tool because it harnesses the wisdom inherent in the aggregate opinion of investors. Like anything else in the financial markets, the market’s opinion is not always correct, but in our experience, it proves itself as accurate more often than not (and certainly more often than my brother-in-law). Whether or not you choose to adopt a momentum strategy to allow you to gauge the market’s opinion is up to you. The only thing we ask is that you turn off CNBC so that the crowd we listen to remains as wise as possible.