Momentum Sails On, For Now

One of the best performing equity investment themes in recent years has been Momentum – winning stocks have kept on winning while losers have struggled to turn things around. But could there be a Momentum ‘crash’? We analyze recent and historic performance and assess the risk.

Long-Term Performance

At its simplest, the price momentum strategy involves buying the stocks that have performed best in the recent period and selling the worst performers. A typical method, that we will use as the basis for this analysis, assesses the performance of stocks using the past 10 months as the formation period, but excluding the most recent month as markets often experience reversals in the short term. Within the Systematic Equity team’s Alpha model, we have a theme called Sentiment - this is made up from a combination of signals to create a more sophisticated, nuanced yet broadly diversified momentum-like set of exposures.

Momentum and Value have been at the heart of many systematic equity strategies over the past few decades. As we recently discussed in our examination of Value signals (Waiting for Value: Time to Reassess ‘Cheap’ Equities?), a momentum strategy has performed very successfully over the long term and has been outperforming Value in recent years, albeit with a wobble at the end of February and into March.

Adding to the appeal of combining Value and Momentum has been the low, but negative, correlation in returns. Although time-varying the low correlation offers diversification; when Value does poorly, Momentum often does well with the result of smoothing the overall return profile of the combination. In the most recent period, the return correlation has been around the long-term average.

Although the long-term returns of Momentum are extremely attractive on both an absolute and relative basis, there have been periods of sharp falls, known as “Momentum Crashes”. These typically occur in periods of recovery after a crisis when the old world order is turned on its head and the winners become losers, and the vice-versa. The most significant example of that in the past 35 years was in 2009 at the height of the Global Financial Crisis after the Federal Reserve Bank unveiled its TARP program, and investors realized the financial system was actually going to survive (even if wounded). The cheapest, most distressed securities (many of them financial stocks) rallied strongly, leading to a significant crash in the momentum factor.

To analyze the momentum crash phenomenon further, we divided the 3-month returns for the momentum signal into three: the top 5% of return periods we classified as “Boom”; the worst 5% as “Crash”; and the rest as “The Rest”. In Figure 3, the table shows average characteristics in these periods alongside comparisons with the current environment.

The average three-month return in boom periods was 22.9%, in crashes it was -10.2%, and in other periods it was 1.2%. Interestingly, after a Momentum crash, returns to the factor have rebounded over the following 12 months, although on average not fully recouping their losses. In boom periods, however, we have not observed mean-reversion to the same extent.

Analyzing the above table, we can see Momentum crashes have taken place in periods of increased volatility and weak equity markets, which then typically rebound significantly over the subsequent 12 months. The current environment, by contrast, has been one of strong momentum returns, robust market returns, and low volatility.

Demonstrating the diversification benefits of combining Value with Momentum, we note that in the Momentum crash periods Value on average would have helped reduce the drawdown by returning +2.7% and continuing to add return over the next 12 months.

The Bottom Line

The current market environment does not look like that typically seen in past Momentum crashes, but that does not mean that we won’t see some rotation out of Momentum at some point this year. Timing factor returns over the short term is notoriously difficult, and particularly so in the current news-driven cycle of tariffs, political U-turns, and geopolitical upheaval.
Within our Alpha model and Active portfolios, we aim to be diversified and maintain positive exposure at all times in the cycle to the four key themes we believe drive returns within markets: Sentiment (Momentum), Value, Quality, and Catalyst.

Careful consideration of the signals we use within the Sentiment theme and thoughtful weighting of Sentiment with the other diversifying factor themes allows us to capture the long-term return power from the theme, whilst reducing the overall impact of potential Momentum drawdowns on active returns.