My Thoughts On Momentum Investing

I believe that more money can be made by buying high and selling at even higher prices. I take exception to the idea of buying low and selling high – Richard Driehaus, the father of momentum investing

Preface

Allow me to start by stating unequivocally that I am not a dedicated momentum investor. Nor am I a dedicated value investor. In fact, if you want to put a label on me, I am probably best described as a thematic investor. I believe in certain themes (aka megatrends) taking control of the world we live in and, if you can identify and invest correctly in those themes, it actually makes little difference whether the companies you end up investing in can best be described as one or the other.

In last month’s Absolute Return Letter – How (Not) to Value Equities – which you can find here , I made the point that momentum investors shouldn’t be overly concerned about the point I made, i.e. that the returns on U.S. equities over the next decade are likely to fall dramatically short of the returns we have gotten used to in recent years.

I have had a few comments and questions on the back of that argument. It is therefore only natural that I elaborate on the point I made. What do I really mean when I say that momentum investors shouldn’t pay too much attention to how expensive markets are? And which signals do I use to detect when, suddenly, it isn’t irrelevant anymore? In this month’s Absolute Return Letter, I will dig deeper on those two questions.

A bit of history

I am old enough to remember the boom and bust in Japan in the late 1980s and early 1990s and, likewise, the dotcom boom and bust in the U.S. some ten years later. I think of those two incidents virtually every day, as I remind myself of not falling into the same trap again.

Momentum investors had a feast in Japan in the late 1980s, and they enjoyed it no less in USA a decade later. I was the new kid on the block in Copenhagen when Nationalbanken (the Central Bank of Denmark), in January 1984, relaxed the rules to do with investing abroad. For the first time ever, ordinary Danes were allowed to invest in non-Danish equities.

Coincidentally, the ‘party’ in Japan started at about the same time. Day after day, and with few questions asked, clients filled their pockets with Japan equities. A new generation of momentum investors had been born. About ten years later, the story repeated itself although, this time, it was all about a new phenomenon we hardly understood. Those who did, called it the internet . Again, momentum investors made fortunes on companies we had never heard of before.

Everything was fine until, suddenly, it wasn’t. In Japan, the party ended abruptly in 1990 due to a combination of government policy tightening and structural weaknesses in Japan’s financial system which had been exposed. Ten years later, in USA, the story broadly repeated itself. A worried Fed had increased the policy rate no less than six times between the summer of 1999 and the spring of 2000, and, suddenly, financial markets snapped.

However, the point I want to make is a different one. At least two years before the party ended, both in Japan and in USA, you could have made exactly the same argument. Take for example the dotcom boom. Had you invested exclusively in the Nasdaq index to participate in the boom (as a dedicated momentum investor would have done) but sold it all at the end of 1997, as somebody had told you valuations were now ridiculous (as they were), you would have missed +40% in 1998 and +86% in 1999. In other words, exiting prematurely is associated with significant career risk.

Exhibit 1a: S&P 500 momentum relative to S&P 500 since 1972

Exhibit 1b: MSCI World momentum relative to MSCI World since 1972

Take a quick look at the charts above. As you can see, in the US (Exhibit 1a), momentum investing has enjoyed a fabulous 54 years since 1972. Only in the first few years after the dotcom bust in 2000 did momentum investors significantly underperform; however, over the entire period, momentum investors have performed dramatically better than index investors – by a factor 5x.

The picture is modestly different in Exhibit 1b (global equities). In the first three decades, momentum actually underperformed; however, since the early 2000s, momentum investors have outperformed index investors when investing globally and, over the entire period, they have outperformed by a factor 3x.

The father of momentum investing in a few words

Richard Driehaus, who unexpectedly died in 2021, is widely recognised as the father of momentum investing. He identified and bought stocks when they have strong upward price momentum and held on to them, as long as the momentum continued. He focused on small- and mid-cap companies with accelerating earnings growth and emphasised companies that are capable of delivering significant, positive earnings surprises.

Key to his success was his ability to hold on to his winners whilst quickly getting rid of his losers – something we could all learn from. Another key was his willingness to diversify during bad times and to concentrate his holdings during good times. He had four key metrics he followed religiously:

1. positive earnings surprises;
2. sharp upwards revisions in consensus earnings estimates;
3. accelerating earnings & sales; and
4. very strong, consistent and sustained earnings growth.

Even better if the earnings growth was not only year-on-year but also sequential; however, of the four metrics, Driehaus probably assigned most value to #1. If you want to learn more about the methodology conducted by Richard Driehaus, I suggest you read this 2021 article in Forbes Magazine .

What have I learned so far and what can I learn?

In terms of how to deal with seemingly overvalued equity markets, by far the most important lesson I have learnt from a long career in the industry is that booms don’t turn to busts just because equities are overvalued. A catalyst shall be required. As I pointed out earlier, in the two incidents mentioned in this month’s letter, aggressive monetary tightening did the trick.

That said, the U.S. monetary policy regime has changed since the late 1990s; the focus is no longer on inflation only. Adding to that, U.S. households own colossal amounts of equities. It would take a man with nerves of steel to end this party. Furthermore, the current tenant of the White House is (i) addicted to debt and (ii) prepared to fire FOMC members who don’t dance to his tune. All of this means that the current (seemingly illogical) behaviour can continue for much longer than most of us expect, and that the catalyst, when it eventually arrives, will most likely be something we hadn’t thought of.

This doesn’t imply you shouldn’t take your precautions. In last month’s Absolute Return Letter, I listed five particular lines of action we have taken to take risk out of our portfolio. We:

1. 1. significantly reduced our exposure to U.S. equities, the most expensive on Earth;
2. 2. didn’t go into cash but instead increased our exposure to Europe, Canada, Japan and China;
3. 3. significantly lowered the equity beta in our portfolio;
4. 4. increased the exposure to certain commodities (mostly industrial metals); and we
5. 5. bought gold.

Looking forward, what is the most important danger signal that I look out for? There are obviously many – financial magazines putting a big story on the front page is always a good contrarian indicator – but one stands out to me. Going back to momentum investing and Richard Driehaus, when investors start to react negatively

unless the positive earnings surprise is substantial, all the red lamps start flashing in my office. Unfortunately, I have seen a few of those in recent weeks. Now, one swallow doesn’t make a summer, but it is an indicator I follow keenly, and I will strongly suggest you do the same.

Niels

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Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.