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Value Vs. Momentum Performance
- We are seeing a strong and clear Poor-Value/Strong-Momentum pattern emerge, which could indicate a looming market top. While QE3 could disrupt it, the pattern looks unmistakable so far.
- This is telling us to be cautious, for while the present circumstances favor Momentum, a switch to a more Value-oriented strategy may be necessary should the market roll over.
Value and Momentum strategies have long been the bread and butter of quants. These strategies are simple to construct and work better than most other quantitative strategies over time. In our last look at this topic in October 2010, we highlighted the following relationship between Value and Momentum strategy performance* around market tops and bottoms:
- At market tops, Value tends to perform poorly while Momentum performs well.
- At market bottoms, Value performs well while Momentum suffers.
As the chart below shows, Value and Momentum have exhibited this pattern at all three previ- ous major market tops (boxes with down arrows) and bottoms (boxes with up arrows).
* The Momentum strategy is a portfolio that goes long the past 12-month winners and 1-month losers and short the past 12- month losers and 1-month winners. In other words, it is betting on longer-term momentum to continue and very short term mo- mentum to mean revert. The Value strategy is a portfolio that goes long cheap stocks (as defined by an assortment of traditional valuation metrics such as earnings yield, dividend yield, book/price etc.) and short expensive stocks. We use our global 5000 stocks universe throughout.
In both 2010 and 2011, we witnessed the re-emergence of the Poor-Value/Strong-Momentum pattern, and both times it led to an interim market top. But the patterns and their subsequent market corrections in both years proved to be quite short-lived, and the market went on to make new highs. However, we are now seeing a much stronger and clearer Poor-Value/Strong-Momentum pattern than the ones seen in the last two years.
The average time from the start of the pattern to the following market top is eight months. The current strong pattern started in February 2012, which puts the market top around October 2012. If this pattern holds, we could be in for a surprise with a much worse result than the previous two. The big caveat is obviously QE3. The two previous patterns were cut short by QE2 and Operation Twist. QE3 could disrupt the current pattern, pushing out the market top yet again... But so far the pattern looks solid.
What If The Market Rolls Over?
Now that we’ve got you all worried, a natural question is “what should we do if the market does roll over?” We believe it would be a good time to favor Value. As seen in the top chart at right, the message is pretty clear: V alue performs poorly prior to the peak but starts turning around a couple months after. Although we are not yet calling the market top, the current trend looks uncomfortably similar to the historical pattern when we overlay the last twelve months’ Value performance.
The same can be said about Momentum. Its stellar run over the past year or so tracks the historical pattern quite well (chart at right). But after the market peaks, it tends to be much less effective, basically fading into a sideways pattern.
Although Value and Momentum strategies are easy to implement, it’s not necessarily easy to understand how they work. Numerous studies have been performed over the years by academics as well as practitioners, but we think an overlooked area of the relationship between Value and Momentum is convergence versus divergence.
Value investors buy cheap stocks and sell expensive stocks, hoping their cheap stocks will get more expensive and expensive stocks will get cheaper. In essence, Value strategies are trades that bet on the convergence of valuation towards the mean. Value works best when the cross-sectional dispersion of valuation narrows from a high level, and vice versa. The chart below shows a strong negative relationship between Value performance and its cross-sectional dispersion (proxied by the cross-sectional standard deviation of earnings yields). In the last year or so, valuation has been diverging from a very low level, which is a very tough environment for Value strategies.
On the other hand, Momentum strategies bet on winners to keep on winning and losers to keep on losing; they are divergence trades where you bet on return spreads between the winners and the losers getting wider instead of narrower. Momentum tends to work best when the cross- sectional dispersion of returns widens from a low level and vice versa. The bottom chart shows there is a strong positive relationship between Momentum’s performance and the cross- sectional standard deviation of 12-month minus 1-month momentum.
The convergence of Value and Momentum dispersion seen from 2010 to 2011 does not happen very often. The main suspect is the Fed (and its global siblings), which pushed up all asset prices, in- creased correlations at all levels, and reduced the yields and expected future returns for all asset classes. At first glance, the Momentum dispersion is currently increasing from a low level, which bodes well for the continued outperformance of Momentum strategies. But we think the current low Momentum dis- persion level is artificially suppressed by the central bank interventions over the last two years. We might be much closer to an interim dispersion peak than the number suggests. This dampens our enthusiasm for Momentum quite a bit.
On a brighter note, the conditions necessary for good Momentum performance are still intact. In previous reports, we’ve highlighted the liquidity link between the relative performance of Value and Momentum. Value, besides being a convergence trade, is a liquidity-providing strategy where you buy into lower prices and sell into higher prices. Momentum, on the other hand, is a liquidity-consuming strategy where you buy into higher prices and sell into lower prices. In other words, a friendly liquidity environment is needed for Momentum to perform well.
The chart below shows a strong negative relationship between Value/Momentum relative perfor- mance and the 10-year swap spreads (a liquidity proxy). Today’s global liquidity environment is espe- cially friendly for Momentum. From this perspective, it’s still likely to continue its strong outperfor- mance versus Value. But liquidity conditions are fluid, to say the least. It would only take another risk event for global credit markets to freeze up and liquidity to evaporate overnight, creating a Value- friendly environment. But at this point, it looks like the best chance for Value managers to get a bonus this year is an imminent risk event or bear market.
Value’s poor performance in the last twelve months is so pervasive that it has suffered in almost all regions and sectors. Even traditionally fertile grounds for Value investing have not been spared. Asia ex-China ex-Japan has been one of the best regions to harvest value premium, but the last couple of years have seen very disappointing performance for the Value strategies. Historically, Momentum has not been a consistently good strategy for this region, but it has produced much better performance in recent years.
Europe has popped up on various screens as its valuation has been quite depressed. The Poor- Value/Strong-Momentum pattern emerged in early 2010, way earlier than in most other regions. But lately it has shown a glimmer of hope, with Value turning up and Momentum turning down (typically indicating a market bottom). We caution against getting too enthusiastic about bottom-fishing in Europe right now, as these rays of hope have come before, only to be blanketed out by more darkness.
Financials, traditionally another productive area for Value investing, have seen weak Value per- formance in the last twelve months (chart below). The long deleveraging process, re-regulation and liti- gation headwinds have prevented companies from realizing their value premiums. Going forward, the ultra low interest rate regime poses big margin challenges for these companies. It will not get easier for distressed/cheap companies to find their way back to growth any time soon, which bodes ill for Value within this sector.
Finally, some good news for Value investors. The Energy sector has bucked the trend, generat- ing impressive performance for Value strategies lately (chart below), and it doesn’t look like this trend is ending any time soon. This is the only sector where we have not seen the Poor-Value/Strong-Momentum pattern typically associated with a market top. This bodes well for the entire sector, regardless of investing style.
The Bottom Line
We don’t want to fight the Fed, but the Poor-Value/Strong-Momentum pattern tells us to be cau- tious right now. QE3 could disrupt the pattern, but that has yet to happen. Widening valuation spreads and abundant liquidity are all negative for Value strategies, while increasing return spreads are positive for Momentum strategies. But all could change if another risk event hits and the market rolls over. That’s when we would favor Value over Momentum. In the mean time, Value investors might have to look in the Energy sector for some consolation prizes.
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