It's quite a daft premise really but, in general, constructing a portfolio full of stocks that have risen the most over the previous year or so gives you the highest probability of making a profit in the coming months. Between the end of WWII and 2008 a strategy that went long recent winners and short recent losers (i.e. top and bottom 10% of stocks ranked by 1 year price performance) returned an annualised 16.5% with remarkably low volatility. So strong is the return to these long-short momentum strategies and so universally is it witnessed across sectors and asset classes that billions are allocated to it by fund management groups globally.
Victor Niederhoffer, the famous quantitative trader, once poetically described statistical trading strategies such as this as 'like collecting nickels and dimes in front of a steamroller'. Indeed, hidden within the smooth and strong profit line of this momentum strategy lurks a black swan with a nasty bite. It displays what is known as 'negative skewness' - every once in a blue moon profits from the strategy completely and utterly collapse, wiping out careless traders in the process.
What happens in a momentum crash
In April 2011 Kent Daniel published the research paper '*Momentum Crashes' to investigate this phenomenon. A long-short momentum portfolio is created by going long the 10% of stocks with the strongest previous 12 month performance (winners) and short the 10% of stocks with the weakest (losers). He discovered that since 1926 there have been several periods during which the profits from this 'winner minus loser' strategy dramatically crashed, most notably March to December 2009 and the period from 1932 through to the end of World War II.
In normal times the winner portfolio outperforms the loser, but during such a momentum crash the loser portfolio massively outperforms the winners. Daniel illustrated this with the fact that over the 3 months between March and May 2009 the winner portfolio rose by only 6.5% but the loser portfolio (or the stocks that had collapsed the hardest in the financial crisis) rose by 156% ! Anyone short the losers clearly had a miserable time and probably went bust in the process.
Essentially, what is happening in a momentum crash is that the worst performing stocks in the market, the losers, rebound dramatically more quickly than the winners.
Thus to the extent that the strong momentum reversals we observe in the data can be characterized as a crash, they are a crash where the short side of the portfolio - the losers - are crashing up rather than down.
For anyone who was trading in 2009 this may come as little surprise. At the time fund managers were attempting to generate liquidity at any cost in order to pay for redemptions. In order to do so they sold bargain stocks indiscriminately. When the market turned these stocks recovered in astonishingly quick fashion.
The signs of an impending momentum crash
Clearly there are profit opportunities from spotting the signs of an impending momentum crash. The sharp eyed amongst readers will have noticed that both the momentum crashes mentioned above occurred after the nadir of terrible bear markets when volatility was at excruciating highs and when the three year market return had turned significantly negative. Indeed these signifying factors were present during other less calamitous momentum crashes such as in 2002. But the most severe momentum losses do not happen as the market collapses but after the nadir when the overall stock market is beginning a quick recovery.
During the drawdown that precedes a momentum crash the make up of the winner portfolio becomes heavily skewed towards safe, defensive (low beta) stocks, whereas the make up of the loser portfolio becomes heavily weighted with high bankruptcy risk, highly volatile, distressed bargains. (A sure sign that the loser portfolio may be about to significantly outperform is when it's beta hits 3 or more.) The loser portfolio effectively acts like a severely out of the money put option that pays off handsomely when the market recovers.
Some lessons for long-only investors
Before anyone begins to reel in terror away from using momentum in their stock picking strategy, it's worth reminding oneself that 'momentum crashes' describe what happens in a long-short portfolio rather than the typical long-only portfolio that you or I would invest int. Most long only investors should take comfort from the fact that during a momentum crash the winner portfolio does still rise from an absolute return perspective. It just doesn't work even half as well as buying the losers. While the academics may get their knickers in a twist over momentum crashes, there's really no need for long-only investors to panic - keep using long momentum indicators (Relative Strength, Moving Averages, 52 week highs and the Relative Strength Index) as part of your stock picking process.
For the nimble though, the key takeaways from Kent Daniel's paper is that during vicious market breaks - such as we witnessed in 2009 - the best opportunities to profit come from the beaten down bargain stocks that you wouldn't even wish on your mother in law. When everyone is throwing the baby out with the bathwater, it's actually more profitable over the coming months to invest in the bathwater ! John Templeton famously quadrupled his money in 1939 by buying 100 stocks trading at less than a dollar. The best place to look for those kinds of opportunities is using our dedicated bargain stock screener to find stocks trading at less than cash or less than their liquidation value. In more normal markets these so-called Ben Graham Bargain lists can be full of 'value traps'but during terrible bear market lows they often contain stock market gold.
Filed Under: Momentum Investing,