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I believe more money can be made by buying high and selling at higher prices. I rule out the idea of buying low and selling high – Richard Driehaus, father of momentum investing
introduction
Let me start by saying unequivocally that I am no Dedicated Momentum Investor. Nor am I a dedicated value investor. In fact, if you were to categorize me, I would probably be best described as a specialist investor. I believe that certain themes (aka megatrends) are taking over the world we live in, and if you can identify these themes and invest in them correctly, it won’t actually make much difference whether the companies you end up investing in are better described as one or the other.
In his absolute return letter last month – How (not) to value stocks – which you can find here I made it clear that momentum investors should not be overly concerned about the point I made, namely that returns on US stocks over the next decade are likely to fall significantly below the returns we have become accustomed to in recent years.
I’ve had some comments and questions on the back of this argument. So it is natural for me to expand on the point I made. What do I really mean when I say that momentum investors shouldn’t pay as much attention to how expensive the markets are? And what signals do I use to detect when suddenly something is no longer relevant? In this month’s Ultimate Return Post, I’ll delve deeper into these two questions.
A bit of history
I’m old enough to remember the boom and bust in Japan in the late 1980s and early 1990s, and similarly, the dot-com boom and bust in the United States about a decade later. I think about these two incidents almost every day, and I remind myself not to fall into the same trap again.
Momentum investors were celebrating in Japan in the late 1980s, and enjoyed it no less so in the United States a decade later. I was the new kid on the block in Copenhagen when… National Bank (The Danish Central Bank), in January 1984, relaxed the rules regarding investment abroad. For the first time ever, ordinary Danes were allowed to invest in non-Danish stocks.
Coincidentally, the “party” started in Japan around the same time. Day after day, with few questions, clients filled their pockets with Japanese stocks. A new generation of investors has generated momentum. About ten years later, the story was repeated, although this time it was about a new phenomenon that we barely understand. And those who did so called him Internet . Once again, momentum investors have made fortunes from companies we’ve never heard of.
Everything was fine, until suddenly it wasn’t. In Japan, the party ended abruptly in 1990 due to a combination of tightening government policy and structural weaknesses in the Japanese financial system that were revealed. Ten years later, in the United States of America, the story was widely repeated. The worried Fed had raised interest rates no less than six times between the summer of 1999 and the spring of 2000, and suddenly the financial markets collapsed.
However, the point I want to make is a different one. At least two years before the party ended, in both Japan and the USA, you could do this exactly Same argument. Take, for example, the dot-com boom. If you had invested exclusively in the Nasdaq to participate in the boom (as a professional momentum investor would have done) but sold out at the end of 1997, as someone told you that valuations were now ridiculous (as they were), you would have lost over 40% in 1998 and 86% in 1999. In other words, exiting prematurely is associated with significant career risk.
Figure 1a: S&P 500 Momentum Compared to S&P 500 Index Since 1972
Source: Bloomberg
Figure 1b: MSCI World Momentum compared to the MSCI World Index since 1972
Source: Bloomberg
Take a quick look at the charts above. As you can see, in the United States (Figure 1a), momentum investing has enjoyed a remarkable 54 years since 1972. Only in the first few years after the dot-com crash of 2000 did momentum investors underperform; However, over the entire period, momentum investors performed significantly better than index investors – by a factor of 5x.
The picture is slightly different in Figure 1b (global stocks). In the first three decades, momentum actually performed poorly; However, since the early 2000s, momentum investors have outperformed index investors when investing globally, and over the entire period, they outperformed by a factor of 3x.
The father of momentum investing in a few words
Richard Driehaus, who died unexpectedly in 2021, is widely known as the father of momentum investing. He identifies and buys stocks when they have strong upward price momentum and holds them as long as the momentum continues. Focus on SMEs as they accelerate Earnings growth He emphasized companies capable of achieving large and positive surprises in profits.
The key to his success was his ability to retain winners while quickly eliminating losers – something we can all learn from. Another key was his desire to diversify during bad times and concentrate his holdings during good times. He had four main standards that he followed religiously:
- Positive earnings surprises;
- sharp upward revisions in consensus earnings estimates;
- Accelerate profits and sales; and
- Very strong, consistent and sustainable earnings growth.
Better yet, earnings growth wasn’t just year-on-year, it was sequential as well; However, of the four scales, Driehaus probably assigned the most value to number 1. If you want to learn more about the methodology conducted by Richard Driehaus, I suggest you read This is a 2021 Forbes article .
What have I learned so far and what can I learn?
As for how to deal with stock markets that appear to be overvalued, the most important lesson I’ve ever learned from my long career in this industry is that booms don’t turn into busts just because stocks are overvalued. A catalyst must be needed. As I noted earlier, in the two incidents mentioned in this month’s letter, it was strong monetary tightening that succeeded in achieving the goal.
However, the US monetary policy regime has changed since the late 1990s; The focus is no longer only on inflation. In addition, American households own huge amounts of stocks. It’s going to take a man with nerves of steel to end this party. Moreover, the current tenant of the White House is (1) addicted to debt and (2) willing to fire FOMC members who don’t dance to his tune. All of this means that the current (seemingly irrational) behavior can continue for a lot longer than most of us expect, and that the trigger, when it eventually comes, will likely be something we haven’t thought about.
This doesn’t mean you shouldn’t take precautions. In my ultimate return letter last month, I listed five specific lines of action we’ve taken to de-risk our investment portfolio. we:
- 1. We significantly reduced our exposure to US stocks, the most expensive on Earth;
- 2. We did not resort to cash, but instead increased our dealings with Europe, Canada, Japan and China.
- 3. Significantly reduced the beta of stocks in our portfolio;
- 4. Increased exposure to certain commodities (mostly industrial metals). And we
- 5. He bought gold.
Looking ahead, what is the most important red flag to watch for? Obviously there are many such articles – financial magazines having a big story on their front page is always a good contrarian – but there is one that stands out in my opinion. Going back to momentum investing and Richard Driehaus, when investors start to react negatively
Unless the positive earnings surprise is significant, all the red lights start flashing in my office. Unfortunately, I’ve seen quite a few of these in recent weeks. Now, one swallow doesn’t make a summer, but it’s an indicator I follow closely, and I would strongly suggest you do the same.
Nils
Editor’s note: The summary points for this article were selected by Seeking Alpha editors.
