7. The First Factor: Momentum—Befriending the Trend
If there is one thing that Wall Street loves to do, it’s coin an adage. “Don’t fight the Fed!” some market veterans will chide. “Don’t fight the tape!” others caution, referring to the long strips of paper containing stock quotes that once spewed out from what was known as the “ticker” in the days before computers made obtaining the latest share price data as simple as clicking a mouse. When markets are particularly volatile or heading south rapidly, cheap markets tend to get cheaper. That’s why the mantra “the trend is your friend” has become the most widely used (or overused) catchphrase on Wall Street.
What these phrases share is a focus on momentum, and specifically the need to be cautious about investing when momentum dominates financial market activity. Remember the old Road Runner cartoons that all of us watched on Saturday and Sunday mornings? As Road Runner zipped along the roads at the speed of light, the hapless Wile E. Coyote sped after him in an endless and fruitless quest to catch his prey. In each episode, there was always one moment when Wile E. Coyote became so carried away with his pursuit of Road Runner that he doesn’t realize his mad rush has carried him over a cliff. Only when it’s too late does it dawn on him that there is no solid ground underneath his paws. He tries to run faster, in a vain bid to get back to the roadway, but instead plunges to the bottom of the canyon. The triumphant Road Runner carries on his way with a jubilant “beep-beep.”
Dealing with our first factor, momentum, can be just as tricky as chasing Road Runner. As all the Wall Street mantras imply, trying to bend momentum to our will can lead us to disaster in just the same way that the Wile E. Coyote’s reckless pursuit leads him over the cliff edge time after time. (Alas, the damage you can do to your portfolio in the process isn’t usually as quickly repaired as that to the fictional Wile E. Coyote, who miraculously reappears intact in the next episode.) Ignoring it is foolish; getting carried away with it is also hazardous. So what if the trend is our friend? As my mother never stopped telling me, “If your friend jumped off a cliff, would you do that too?”
Trends dominate financial markets, and momentum shapes those trends. Befriending a trend doesn’t mean following it blindly. Rather, you must recognize the point at which that trend is old and about to shift gears, alter direction, or simply vanish altogether. Year in and year out, economists and investment pundits deliver a steady stream of forecasts that one trend or another is about to end. It’s always something dramatic, because telling readers or viewers that financial stocks are still in the doldrums isn’t going to appeal to them. Rather, it’s the new, new thing that grabs their attention. Logically, then, the soothsayer who is predicting something downright bizarre—say, that the Dow Jones Industrial Average is about to double—will get the most media attention, as long as he or she can put forward a logical argument in support of that prediction. Take a look at the overstock table in a bookstore sometime, covered with the unsold and outdated hardcover books that once were trumpeted as the season’s must-read works. There you’ll find, gathering dust, provocative titles such as Dow 40,000: Strategies for Profiting From the Greatest Bull Market in History, by David Elias, published in June 1999. As we all recall, less than a year later, investors were reeling from the implosion of this greatest bull market; a decade later, the Dow was further from, rather than nearer, that 40,000 mark. Then there was Bear Market Investing Strategies, by Harry D. Schultz. Ironically, it was first published in July 2002, months before the start of a 5-year bull market. So much for capturing the trend.
Once you start thinking about all the competing arguments pundits make in favor of their pet trends, you’ll probably start to realize just how many flawed prophets there are out there. Throughout 2005 and 2006, for instance, scores of analysts predicted the imminent demise of the small-cap rally. Nevertheless, as I discussed in the preceding chapter, small stocks continued to outpace the S&P 500 month after month until early 2007. I confess that I’ve occasionally been caught up in the temptation to call for the end to a trend, predicting, for instance, that real estate investment trusts (REITs) would lag in 2005 and 2006. Alas, being early is just another way to be wrong in the financial markets. Even the most experienced and successful investors end up dismayed and baffled by the continued outperformance of an asset class or category that they firmly believe is poised for a cyclical slump or that is overvalued.
In fact, trends are much more powerful, resilient, and long-lasting than we like to admit. That means investors are tempted to make two different kinds of asset-allocation errors, both of which undermine our ability to make solid investment decisions. One of the most common is the one I have already referred to. The longer a rally continues, the more overstretched valuations become, the more nervous I know that I become, and the more likely I am to unilaterally decide that the rally is over (long before the trend itself is ready to give up the ghost). Or else we stay too long at the party and end up bleary-eyed and hung over, cleaning up after everyone else has gone home. Market trends may excite human emotions in investors, but they don’t respond to those emotions. Cheap markets get cheaper, bull markets drag on and on. Make a move out of impatience, and the price you pay could be a high one. Back in early 2005, the real estate market’s fundamentals made REITs look like a costly and risky investment. Yields on publicly traded real estate trusts, a key valuation indicator, had fallen to historic lows relative to 10-year Treasury notes. But the positive momentum still ruled the day. The Bloomberg index of REITs climbed 11.6% in 2005 and soared another 33.9% the following year. It wasn’t until 2007 that the valuation issues finally interrupted the momentum.
Any model that emphasizes other factors, even such a crucial one as valuation fundamentals, at the expense of momentum is one that contains a fatal flaw. Yes, other factors can draw your attention to a potential problem, but it’s the momentum factor that will tell you about the timing of a correction or rebound. Misreading a momentum indicator is just as perilous as overlooking momentum altogether. Anyone who decided in early 2000 that the momentum of the previous few months would continue into the spring and summer paid a heavy price when the dot.com bubble finally burst, just as anyone who responded to Fed Chairman Alan Greenspan’s warning about “irrational exuberance” in late 1996 would have forfeited 3 years of rich stock market returns. So the key to being a successful global macro investor is buying markets when they are cheap and about to increase in value, while shunning those that are costly and about to see valuations contract. Of course, you need other factors, notably valuation fundamentals, to help you distinguish which markets are which. But only momentum can help you with the second step: figuring out when those valuations are about to change and adjusting your portfolio accordingly.
If you have a broker or financial advisor helping you with your investment portfolio, he or she probably reminds you a lot—especially during bear markets—that you need to be invested in stocks most of the time. History has shown that about 30% of a bull market’s move occurs in the first three months of a rally. Being late to the game can cost you massively in terms of foregone profits. But even the most skilled investors have demonstrated over and over again that they can’t predict when a market is about to shift directions. That’s one reason why pundits refer scathingly to “market timing” as a strategy doomed to fail. Another reason for staying invested in the market is that uptrends in stocks tend to last longer than downtrends. Over the past 50 years, the 30 stocks in the Dow Jones Industrial Average posted gains in 129 quarters but only lost ground in 74 quarters. If you’ve just experienced one positive quarter, there is a 53% chance that the next will also be profitable, according to historical models. What makes it tough for investors to stay put, and the reason that your adviser probably has to prod you to do so, is that the quarters in which market indexes fall are painful to endure. Yes, the typical downtrend may be rare and short-lived, but it’s also more pronounced than are the gains in the positive quarters. (Optimism and enthusiasm take months or years to manifest themselves; panic can develop overnight.) Of the five 3-month periods in which the Dow benchmark has been most volatile over that 50-year period, three of them saw big downward movements. The worst? Not surprisingly, it was the fourth quarter of 1987, during which the Dow plunged an astonishing 25.3%. (The autumn of 2008 may have felt worse to investors who don’t have a firsthand recollection of 1987, but in fact, the Dow slid less than 18% in the third quarter of that year.)
Let’s say that all the other metrics you study are telling you a bull market is getting a bit long in the tooth or that a valuation gap that has existed between two asset classes is about to correct itself. Naturally, you’re eager to jump in and take a position to profit from that over-or undervaluation; that’s human nature. Before you act, however, ask yourself whether you’re about to behave like a cartoon coyote, ignoring the rules of momentum and ending up splattered on some canyon floor. Instead, you need to find a way to work with a trend that you identify. If you develop and use a set of momentum-based metrics, you will be able to pick your entry point more astutely, or identify the moment when it is prudent to head for the exit. If you manage those momentum indicators properly, you’ll equip yourself with a virtual set of brakes: Even if you find that a market in which you have invested no longer has any visible means of support, you’ll be able to slow down and shift direction in time to avoid heading over the cliff.
Momentum is the link that connects theory with reality. Investors can develop a theory that a particular market is expensive and overpriced, drawing on information provided by the other four factors. But that conclusion about valuation is still only theoretical. It becomes relevant—and something that you should act on—only when perception becomes reality. When investors aren’t just worrying about a market being risky but seeking shelter by selling, you are dealing with reality. The momentum has shifted. If you grasp the momentum factor, you will be able to determine when to act, and be aware of exactly how rapid or forceful a particular change in market direction seems likely to be.
The ultimate trend junkies are technical investors, so some of the momentum metrics you might find yourself using are the stock price charts and other tools that these folks employ with an almost religious zeal. Technical analysts, however, tend to ignore other factors. I believe you need to steer a middle course; adopting some key technical models to help you grasp the momentum trends, without shunning or discounting what other factors are telling you. Perhaps the most important of the weapons in a technician’s arsenal is the 200-day moving average. This is generally viewed as the dividing line that tells you when a stock or index looks healthy on a technical basis and is calculated by determining an average of all the prices for a stock (or bond, or index) for 200 trading days in a row. (That roughly equals a full calendar year of trading days.) Then the stock’s current price is compared to where it has been over that 200-day period. Let’s say that other factors are telling you that small-cap stocks are a roaring “buy.” If the Russell 2000 Index (or any other proxy for small-cap stocks that you choose) is trading above its 200-day moving average, I think that’s a reliable signal that it’s time to shift assets into smaller stocks. As long as the index level remains above its 200-day moving average, the bullish trend is intact. When it falls below that line, that serves an equally reliable “sell” indicator.
This tool is so useful that even if you don’t look to other metrics for confirmation, it can prove very helpful. In one study that my team conducted at Harris Private Bank, we discovered that an investor relying on the signals sent by this 200-day moving average would have fared better than another one who just followed the advice to “buy and hold.” Specifically, someone who began investing in December 1980 and bought stocks in the Dow Jones index whenever it traded 1 percentage point above its 200-day moving average, and sold them whenever it dipped 1 percentage point below that average (putting the proceeds in some other kinds of securities yielding an average of 4% a year), would have had, by December 2008, $1,681 for every $100 he had started with. The buy and hold investor, in contrast, would have ended with $890 for every $100 invested (see Figure 7.1).
Figure 7.1 Buy and hold investing versus momentum investing.
Moving averages are just as useful when you want to compare one market against another as they are in identifying entry and exit points in any single market. However, relative market trends tend to last a lot longer than individual market trends. So when you’re trying to understand whether smaller stocks are a better buy than their large-cap counterparts—rather than just trying to pick the right time to buy small caps—you need to use metrics based on longer time periods. For instance, between late 1999 and 2006, investors who bought the small-cap stocks in the Russell 2000 Index earned returns that were 80 percentage points higher than those they would have captured investing in the large-cap universe as represented by the S&P 500. (Over that time frame, the S&P 500 advanced a measly 24.2%, while the Russell 2000 surged 104.9%, including dividends.)
As I’ve noted, pundits were particularly eager to call an end to that long-lasting trend. Ultimately, small stocks (as represented by the Russell 2000 Index) sported a price/earnings ratio that was an astonishing eight times that of those in the S&P 500. Small-cap stocks seemed to defy the laws of gravity, or at least the rules that said big valuation gaps should narrow rather than become larger. But studying the 20-month moving average would have helped an investor trying to predict when that break would happen. It finally did so in the second quarter of 2007. The first clue came when the S&P 500 finally broke above its 20-month moving average. That mirrored what had occurred in December 1999, when small-cap stocks had begun their period of spectacular outperformance by breaking the 20-month moving average of the relative return between large- and small-cap stocks. The stage was set for large caps to outperform, a phenomenon that remained intact even as the stock market spiraled downward throughout the autumn of 2008 (see Figure 7.2).
Figure 7.2 Large caps outperforming small caps.
Commodities investors have been far bigger fans of technical analysis than stock market investors, perhaps because commodity price trends tend to persist longer than those in other markets. Evaluating the Dow Jones Commodity Index between March 1991 and March 2008, my research team found that the odds of one positive quarterly return being followed by another were 59%, whereas the likelihood that one money-losing quarter would be followed by another was only 39%. Obviously, momentum is a powerful force in commodities markets, and timing is crucial, so the momentum factor can have a particularly dramatic impact on these returns. For instance, an investor who used the 52-week moving average in the same way that I’ve outlined above (buying and selling when the prevailing price of the CRB index—the commodity market’s benchmark—was 1 percentage point above or below that moving average) would have turned $1,000 into $2,355 over the 20-year period from December 1988 until December 2008. (That calculation assumes that during periods when commodities weren’t attractive, he or she had parked that capital in Treasury securities earning a 4% annualized return.) Meanwhile, the buy and hold strategy would have left an investor with only $893 per $1,000 invested (see Figure 7.3).
Figure 7.3 Buy and hold versus using the 52-week moving average.
Moving averages tell us a lot about the direction in which a market index is heading as well as its speed. But a process-driven investor needs more information than that, just as when you see a speeding car on the highway, you want to know whether the driver is trained in high-speed driving, if he or she is intoxicated, how well built the car is, whether it is about to run out of gas, what the weather and highway conditions are, and whether there is something ahead likely to bring the speed demon to an abrupt halt. In the financial markets, the force of a particular move is especially critical. Traders keeping tabs on trading patterns throughout the day will draw conclusions about the durability of a big rally or significance of a large selloff by calculating how many stocks took part in the move and the number of investors who participated, as measured by the trading volume. They’ll downplay the significance of a rally, however large, if trading is thin and only a few stocks have driven the index higher. Similarly, they won’t panic if a selloff comes the day after the Thanksgiving holiday, when most investors are on vacation. Knowing the breadth of a stock market move—how many stocks or sectors are participating—can tell us more about the inner workings of any big move than just looking at the index’s behavior. My Chicago Cubs have managed to put together some impressive winning streaks over their 100-year-long World Series drought and even came within a few games of making it to the World Series for the first time in a century in 2008. But a fan looking beyond those win and loss ratios to the sports world’s version of breadth—the skills of their roster of hitters, pitchers, and fielding talent—probably worried how long those streaks could be sustained.
One of the best ways to measure the market’s breadth, and thus the strength of any particular trend, is to study the advance/decline line, often referred to as the advance/decline ratio. As its moniker implies, this is simply a way to compare the number of stocks within an index whose prices are climbing, or advancing, and the number whose prices are declining. Although neither I nor any other money manager worth his annual bonus would turn up our noses at a 1% jump in any market index, some 1% gains are more significant than others. Personally, I’d rather have a 1% gain in the Dow to which all index components contribute to one where only 2 of the 30 stocks are sharply higher. An advance/decline ratio can be constructed for any index or for the market as a whole. The broader the participation, the steeper it appears on the chart, and the more bullish the signals that it is sending to technical market analysts. This momentum metric will tell you the degree to which investors are convinced that the trend will last. If you see a jump in the value of a commodity index in which crude oil is heavily weighted—such as the Goldman Sachs Index—you can’t assume that it’s because of a bull market in commodities. Instead, you need to look beyond the index to see whether crude oil is the only index component that is rising. In that case, you need to ignore the index as an index of the commodity market, pull your cash out of the asset class, and dash for cover. On the other hand, if soybeans, pork bellies, silver, and copper all are participating in the rally to some extent, feel free to celebrate.
To see how this can prove useful in practice, just take a look back to the fall of 2004. A sharp slump left investors worrying that the 2-year-old stock market rally was faltering. From the middle of September to the end of October, the 30 Dow stocks struggled to deal with the possibility of higher interest rates and lower liquidity. On September 14, the Dow closed at 10,318; by October 30, the index had fallen 2.8% to 10,027. Anyone tracking momentum indicators, however, could reassure themselves that the bull market wasn’t over. In fact, despite the slide, the advance/decline ratio was sending an upbeat signal; more stocks rose than fell. Sure, watching a slide is never fun, but investors heeding momentum indicators would have been better positioned to resist the temptation to take to booze to drown their sorrows. Indeed, anyone who used the slump as a buying opportunity would have had extra cause for celebration on New Year’s Eve. From early November through to the end of 2004, the Dow jumped 11%. That move may have caught skittish emotion-driven investors by surprise, but not those familiar with momentum metrics.
It is sometimes hard for me to understand why so many investors focus only on the surface and fail to look beyond the headlines. I suppose it’s a bit like going on a cross-country hike and then encountering a stream or river. It is narrow—I can see the opposite bank easily from where I stand—but the nearest bridge is nowhere in sight. The simplest strategy would be to take off my boots and wade across to the other shore, replace my footwear, and resume my hike. But suppose that instead of a stream, I’m standing in front of a narrow but very deep river, with a strong current? Unprepared, I could be swept off my feet and drown. Similarly, before I jump into the market, I need as much information as I can glean. That information must deal not only with its fundamentals, but the force and conviction lying beneath the surface of any market move. That is what breadth metrics such as the advance/decline ratio can tell you.
Breadth indicators are particularly valuable when the information they provide contradicts what is happening in the market index. At times of maximum bullishness or bearishness, contrarian signals can be hard to detect, much less decipher. This variety, however, is easy to spot and particularly useful. Back in November 1996, for instance, I watched the advance/decline line for the S&P 500 Index start to fall. The fact that more stocks were declining than advancing appeared to suggest that the force of the stock market rally was dissipating. True, many market indicators continued to set record after record over the following years. The Dow Jones Industrial Average, for instance, rocketed to 7,000, then 8,000, and onward to 9,000, with only the occasional blip along the way due to an outside event, such as the emerging markets crisis or the collapse of Long-Term Capital Management in 1998.
But I tried not to be distracted by what the overall Dow index—a relatively small group of only 30 stocks, however important each may be within its own industry—was doing. What preoccupied me was what was happening within the larger S&P 500 Index. Because of its size and scope, measuring this benchmark’s advance/decline ratio is more meaningful. I found that each upward step by that index, each record broken, occurred with less and less participation. By the end of 1999, only 155 of the 500 companies in the S&P 500 outperformed the index itself, suggesting that investors didn’t have much confidence in the future growth prospects of more than two-thirds of S&P stocks. Anyone who spotted that fact might have realized that a bear market was taking shape just offstage. Anyone with an interest in market history would have found the analysis easier still: Back in 1987, when the Dow Jones index reached one new high after another in the months leading up to the crash, the advance/decline ratio was flagging.
Typically, I use breadth indicators as a way to determine whether and when to pull money out of stocks, bonds, or other markets and park it in cash, rather than to tell me about the relative merits of different asset classes. If a market is expensive and running on momentum rather than fundamentals, a deterioration in breadth will often be the best indicator that it’s time to jump off the bandwagon. Best of all, it can be applied to any asset class, including commodities. Back in 2000, for instance, the Dow Jones Commodity Index soared 24%, but the number of its 20 components rising in value slipped from 12 to 10. At the very least, those metrics sent commodity investors a mixed message: Yes, the topline results were bullish from a momentum perspective, but bulls needed to at least consider the possibility that momentum was flagging. Those who heeded that message would have been better prepared for the abrupt about-face by the entire index in 2001, when it plunged 22%. I wouldn’t say that breadth indicators on their own served as a sell signal, but they certainly were the equivalent of a shot fired across the bow. Outsize volatility of this kind is just one reason commodity investing makes me nervous. Just as in the foreign exchange market, it’s hard to establish a “fair” market value for a given commodity. But if you have an overwhelming urge to put your money to work in the world of pork bellies and natural gas, you need to become very comfortable with a wide array of momentum indicators, especially those that provide data on market breadth.
Measuring the market’s internal strength in this way will help you understand just how powerful momentum is in any given asset class or sector. Momentum metrics like this also remind you of the need to look beneath the surface. Investors pay a lot of attention to whether stocks are making new 52-week highs. (That is one of those data points that tend to show up in newspaper and online stock charts and to which CNBC anchors like to point.) But how many 52-week highs are there out there, marketwide? And how many other stocks are posting 52-week lows at the same time? That is more useful information. If I see a stock index setting records when a large proportion of its stocks are setting new highs, that reassures me that the market is, indeed, bullish. If the number of 52-week highs and lows is out of whack, however, this metric can also offer an early warning signal.
Norman Fosback, an analyst and editor of Fosback’s Fund Forecaster, a newsletter based in Boca Raton, Florida, devised a new way to determine when the market is “in gear” (bullish) or “out of gear” (bearish). Whenever his index is rising, that tells him that many stocks are making new highs and new lows at the same time. That tells him that the market’s broad trend, as measured by whatever the index is doing, is unreliable, because the performance of its components is all over the map. His reasoning runs as follows: Under normal circumstances, a significant number of stocks post either new highs or new lows. Even if the proportion of stocks making new highs when the market is rising isn’t remarkable, that is less crucial than the fact that those that aren’t doing so are at least relatively stable. Even if some are unchanged or down slightly, they aren’t hitting new lows. To Fosback and his adherents (I’m more of an interested observer, personally) that means that enough stocks are bullish to neutral to be able to conclude there’s no serious threat to the market just waiting to strike.
The goal of all these momentum metrics is to help you make macro-level investment decisions, the kind that have the most sweeping impact on your overall returns (as I explained in the first chapter). Using them will also help you make those calls with a greater level of confidence and security. We are all greedy for the maximum possible return. I prefer to earn it with the minimum amount of fear, terror, and risk. If you know how and when to turn to momentum indicators, you can look for early signs of changing market trends. Can paying attention to momentum make a big difference in your returns? Absolutely. Let’s say that you were one of the canny investors who, back in early 1990, believed that the recession then underway would end and that technology stocks would prove to be one of the big drivers of long-term investment returns. Assume, for a moment, that your research into market fundamentals drew your attention to the fact that this group was significantly undervalued in both absolute and relative terms. If you acted on that and invested in the Nasdaq 100 Index and held it until the end of 2007, you would have earned $9,797 for every $1,000 you had invested. That translates into an annualized return of about 14.4%, the kind of performance that makes most investors dance for joy.
Of course, you would have taken equally outsize risks to earn those returns—not surprising, when you consider that period includes the worst imaginable 3-year period for technology stocks between 2000 and 2002. That portfolio had an annualized standard deviation of 26.4%, a level of risk high enough to suggest that you were equally likely to have lost your shirt. If you had been able to detect signs that the good times were coming to an end in early 2000, you would have fared still better than you did by holding on through the selloff and the recovery. Had you been able to sell at the peak in March 2000, each $1,000 invested would have earned you a return of $22,244.
Momentum metrics, used correctly, can help you pull your chips off the table at the right time more reliably than any other signals. No, I’m not arguing that you’d all have ended up as billionaires! But anyone who used the signals sent by a 50-day moving average indicator—buying more when the Nasdaq index rose 1 percentage point above the average and then selling when it fell 1 percentage point below the average—over the course of that volatile 17-year period would still have pocketed $10,119 for every $1,000 invested. That’s a 14.6% annualized return and one generating a significantly lower standard deviation of 17.2%. In other words, in exchange for paying attention to the signals being sent by our indicator, we get more return and the ability to sleep more peacefully at night.
The more contrarian the signal momentum metrics send, the more useful they can be. Let’s suppose that our hypothetical investor had decided that using even more momentum metrics would lead, logically, to even more impressive results on an absolute and risk-adjusted basis. Therefore, he decided to hold Nasdaq stocks only when the ratio of new highs to new lows over a 50-day trading period remained positive, on average. There can be too much of a good thing, even momentum indicators, and this is a case in point. That strategy would have caused him to be overly cautious and would have produced an annualized return of only 9.1%, or $4,419 for each $1,000 initially invested. Sure, he would have trimmed his risk level, but only by forfeiting a significant percentage of his potential return. Personally, I don’t want to put undue emphasis on any metric that can cause me to be overly cautious and cost my clients money in the shape of foregone returns. So I tend to think of the high-low indicator as a background indicator of sorts, almost as if it were a warning light on my car’s dashboard that I heed only when it is blinking. In this case, I wouldn’t place too much weight on what this high-low indicator is telling me unless it conflicts with what other momentum metrics are signaling. I value anything that is a contrarian indicator, because that will cause me to double- and triple-check my reasoning.
The momentum factor is one that revolves around what is happening within the markets that I invest in. However, no financial market exists in isolation from the broader world, and often—as we saw dramatically throughout the subprime market meltdown and the ensuing credit crunch and stock market crash—that outside world intrudes dramatically on the markets. That’s why I realized the need to study what is happening in that broader context: the economy.