By Conrad de Aenlle
As the hare in Aesop’s fable discovered too late, it’s better to proceed at a moderate, steady pace than to risk going too far, too fast. We two-legged creatures can get ahead of ourselves, too.
A study by Roger G. Ibbotson of the Yale School of Management and James X. Xiong of Morningstar revealed the consequences that investors can face when they buy stocks after they have already experienced strong and accelerating rallies. Such assets, commonly known as momentum stocks, tend to be coveted by hedge funds and other institutional investors. These pros aim to make a living by latching onto robust trends, which they see as more stable and predictable than other market movements, and therefore more profitable. Xiong and Ibbotson’s study indicates, however, that these momentum plays not only fail to beat the broad stock market, but lag market returns and are prone to sharp, costly reversals just when the upswing in their performance seems to have solidified and strengthened.
The researchers defined an accelerating price pattern in various, common-sense ways. They deemed a stock’s advance to be accelerating, for instance, if its average monthly return for the most recent six months was greater by one percentage point than the corresponding figure for the six months before that—for example, if the share price of Company X gained 2.5% a month over the last six months, say, and 1.3% a month in the previous six months.
Xiong and Ibbotson looked back over nearly half a century of trading activity to select such stocks, carving the historical record into 96 periods of six months each. They compared the returns of momentum stocks to those of all stocks in the month following the one-year qualifying period to try to determine whether price acceleration left a stock vulnerable to a reversal.
They found that it did. The returns of the accelerated stocks trailed those of stocks in general by an average of 60 basis points, or one-hundredths of a percentage point, in the critical follow-up month.
There is an obvious appeal to buying an asset whose returns display increasing strength, but the study confirmed that, like many other stock-picking methods whose worth seems intuitive, chasing momentum is both seductive and expensive. As Ibbotson noted in an interview with Yale Insights, it’s an unsophisticated way for otherwise sophisticated professionals to invest.
“You might think that’s great,” he said. “That’s the naïve view, that if it’s going up, but even going up more recently, that’s wonderful. But in fact it’s overshooting… It means you’re doomed to a fall, basically.”
And maybe not just a minor one.
The authors also tested for evidence that price acceleration left stocks prone to a crash by looking for three effects in the six months following the qualifying period. Two of them, negative skewness and excess conditional value at risk, represent a greater-than-normal tendency for an asset to suffer a large decline. The third, maximum drawdown, measures the largest decline experienced over the period in question. Stocks that had experienced accelerating returns scored higher, on average, on all three crash measures.
A similar phenomenon is visible in the broader market, the authors note: a rapid acceleration of price increases can lead to a crash, as investors learned in 2000 and 2006 when the bubbles in technology stocks and real estate popped.
The momentum effect works in reverse, too, the authors found; individual stocks with accelerating losses tend to outperform and display upward reversals.
There’s some truth to the old adage that the “trend is your friend,” Ibbotson said. But best for investors not to get too chummy with it. “If we all believe the trend is your friend and we all follow that…these stocks become overpriced.”
“Momentum, Acceleration, and Reversal” appeared in the Journal of Investment Management (JOIM), Volume 13, Number 1, in March 2015. It won the journal’s Harry M. Markowitz Award for the best paper published in 2015.