The Rise of Momentum

08/16/2013 6:00 am EST

Focus: STOCKS

Many financial analysts have argued in recent years that the capital markets—stocks, in particular—have changed quite a lot in the 21st century, writes James Picerno of The Capital Spectator.

That’s not surprising, given the fact that there are a host of new players on the scene. The rise of hedge funds, algorithmic trading outfits, and a broad array of other short-term-focused quant shops have altered the landscape. It would be shocking to discover otherwise. Indeed, there’s a whole lot of trading going on, in some cases measured in fractions of a second. What has this evolution wrought? One result is an intensified state of short-and-medium term price momentum.

Consider the evidence in US equities by way of the S&P 500 (SPY) for the past 40 years. Comparing cumulative one-, two-, and three-year rolling returns suggests that the momentum factor has become more pronounced in the 21st century. By comparison, momentum in decades past looks a bit less conspicuous. It was there, of course, but at some point in the mid-1990s the game began to change. No doubt one of the critical events has been (and remains) the use of computers. By comparison, money management was a relatively sleepy affair even as recent as, say, 1980. Some of the changes in recent years are also due to relatively greater extremes in the business cycle. Whatever the drivers, it’s hard to dismiss the sharply higher levels of assets under management that are dedicated to short-term strategies, of which quite a lot are bound up with momentum trades of one form or another.

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It’s difficult to completely explain cause and effect in markets, but this much is clear: the ups and downs in price trends are more distinct, more persistent, and otherwise more explicit than ever. It’s debatable whether this is good or bad news, or even whether it’ll continue. For now, much depends on your perspective.

For long-term investors with the discipline to overlook short-term noise, the change may be a non-event. For short-term traders, this evolution is a golden opportunity, at least in theory. Riding momentum waves can be enormously profitable, assuming one has the skill/luck to call critical turning points with some degree of timeliness. By that standard, recent history has been kind, as implied by the longer and more persistent swings in returns vs. previous decades.

For the average investor with medium-to-long-term investment horizons, however, this evolution presents a mixed bag of implications. On the dark side, there’s greater risk of getting caught up in the noise of the moment, which can distort one’s views on matters of rebalancing. Relatively large and/or persistent swings in prices can look like timely periods to make big changes to asset allocation. But there’s also an increased danger of getting whipsawed by ramping up portfolio turnover without a commensurate payoff.

The solution is to recognize and analyze how the markets have changed and act accordingly. What does this mean? Brief answers won’t suffice here as this is a complicated subject. That said, one implication: there’s never been a better time to reassess your portfolio strategy in context with your stated time horizon and risk tolerance. Are you truly investing for, say, retirement in 20 years? If so, what does that imply for how you’ll deal with the very real possibility that market volatility (VXX) in the short run may be higher and stronger than usual? Meantime, how much short-term risk are you willing to tolerate on the road to reaching your long-term goals. As always, there are no easy answers, or even “right” answers, since these factors should be customized for each investor.

No matter how you proceed, keep in mind that the markets are constantly trying to separate you from your money and on a number of levels the markets have been making progress on this front. It’s reasonable to assume that you’re going to have to work harder to generate the same risk premium through time. There are several reasons behind this creeping competitiveness, and the chart above offers one more reason for wondering if life in the investing trenches is destined to become more challenging.

By James Picerno of The Capital Spectator

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