May 14, 2007
A SHORT TREATISE FOR A TWO-FACTOR WORLD
Investing is subject to the emotions of the moment, the analysis du jour and the exogenous event that unexpectedly and instantly delivers yesterday's pearls of wisdom to the trash heap of history. What then can the strategic investor rely on for true perspective?
In search of an answer, we suggest reviewing the basic forces that propel markets, which your editor believes to be momentum and value factors.
A number of studies over the years have boiled the primary engine of market forces down to these two drivers. And to a degree, common sense suggests no less. Momentum is simply the tendency of price trends to continue, up or down--autocorrelation, as it's called. Value, by contrast, is a condition of excess asset valuation, either or high or low, which leads to a correction in price.
Momentum and value have a long history of generating returns, albeit in sharply different ways, with sharply different types of risks and under varying time periods. Momentum of the bull market variety can stretch out for long periods and render investors complacent with the view that what's past will roll on indefinitely.
By contrast, bear-market momentum has a nasty habit of arriving suddenly and, save for those with a contrarian mindset, without clear warning. In addition, bear-market momentum tends to be relatively short, albeit decisive. In turn, the rapidity of its emergence delivers a fair share of what we'll label the deer-in-the-headlight syndrome, which poses a challenge for fully exploiting the trend.
Meanwhile, the value factor exists in varying degrees over time, wedged in between the fading of bull market momentum and the soon-to-be emergence of bear-market momentum. Value's power and influence, in short, are at a peak during periods of extreme excess in the market. At that point, and for some time after, value decisively overwhelms momentum, slowly giving way to momentum's charms anew.
The two most recent examples of value in its acute and fleeting forms in the equity market came early in this century: March 2000 and October 2002, which captured the crest and trough, respectively, of the S&P 500. At those points, momentum gave way to value, and the latter became the only game in town.
But while momentum eventually gives way to value, value too soon gives way to momentum. In fact, one could argue that value tends to give way sooner than momentum.
Regardless, momentum and value factors are the seeds of opportunity, each in their own right. The two arguably comprise the foundation on which all successful investment strategies are built. (For simplicity, we've conveniently left out such engineered strategies such as merger arbitrage and market-neutral investing.) But while it's easy to identify the laws of nature, turning the knowledge into real-world profit is something else. The reason has more to do with what ails the human mind than for any lack of opportunity in the marketplace.
Indeed, a key risk with bull-market momentum is becoming lulled into its lengthy duration and believing that the trend will continue for longer than fate intends. The danger is giving back some or all of the accumulated profits born of riding a momentum wave. Failing to recognize that momentum is destined to become a value play has tripped up many investors over the generations, and no one has yet presented evidence to suggest otherwise in the 21st century.
Value harbors its own risks too, including the inability to recognize its arrival. That's unsurprising given hat value's onset tends to accompany chaos because it represents a break with the past, a detour from the familiar. In turn, that reverberates with fear in the human mind. If there's one thing the human condition doesn't process efficiently, it's change.
Another danger that forever hangs on the value factor is the inability or unwillingness of investors to recognize when it's out of favor as a driver of returns, meaning that momentum prevails. In fact, value and momentum factors rarely coexist in equal strength, as one always suffers a relatively diminutive role compared to the other. No wonder, then, that investors who excel in one strategy or the other have been known to falter when the other reasserts its historical, albeit temporary reign.
But even among the rarest of birds that can fly in either universe, there is always the challenge posed by the transition's timing. It's never clear in the heat of the moment that momentum is about to give way to value, or value to momentum. Yes, everybody saw it coming after the fact. But when it's unfolding, the true investment oracle on that front is an exceptional breed. To be sure, some will have their suspicions. Even then, some faith is essential since the future invariably remains unclear and full of surprises, even for those skilled at reading balance sheets and dissecting central bank decisions.
Hindsight, of course, reveals all. It's now clear to all that the key to robust gains was focusing on value factors in October 2002. Not long after, momentum became the principal factor that defines the financial universe. In fact, as 2007 nears its halfway market, momentum remains the foremost driver of investment success.
The question of when momentum will give way to value should today be on every investor's mind. With each passing day, the point of transition draws closer. No one knows if it's tomorrow or five years hence. But no one should think that momentum will no longer give way to value, or value to momentum. This is the natural order of markets. It's also the basis for embracing the tenets of strategic investing, which we define as asset allocation, diversification within asset classes and routinely rebalancing the weights of asset classes.
Opportunity is always knocking in money management. But before you answer the door, think about who may be on the other side and be prepared to respond if it's not the guest you expect.
Posted by jp at May 14, 2007 10:08 AM