The Incredible Power of Momentum Stocks
Posted by Eddy Elfenbein on December 6th, 2007 at 8:18 am

I’m a big fan of Professor Ken French’s data library. I’ve used data from his library at this site many times.
If you’re not familiar with Dr. French, he’s a well-known finance professor at the Tuck School at Dartmouth. He’s also known for his long-time association with Eugene Fama at the University of Chicago.
I was digging around some of the files in the library and I was completely stunned by the incredible outperformance of stocks with high momentum, meaning stocks that are surging have a tendency to keep on surging. I was aware of some of the academic literature on this subject, but I have to confess that I was completely dumbfounded by the results.
I know that stocks with favorable valuation characteristics do better than the rest of the market. For example, stock in the lowest decile (or 10%) of price/earnings ratio have historically beaten the market. The same is true for stocks with higher dividend yields or low price/book ratios. Also, small-caps do better than large-caps (although I’m not particularly impressed by the small-cap premium). These phenomena are very well-known and have been documented countless times.
But simply put—high momentum creams them all.
At the data library, French has ten portfolios listed by momentum (see “10 Portfolios Formed on Momentum”). He gets his data from the Center for Research in Security Prices at the University of Chicago. I looked at the long-term returns of stocks with the greatest momentum.
From the beginning of 1927 through August of 2007, the overall market has returned an average of 10.10% a year. The highest momentum stocks returned an average of 17.76% a year.
What’s more, that’s just the value-weighted portfolio. By looking at the equal-weighted portfolio, which gives more say to smaller-cap stocks, the results are even more impressive. The equal-weighted high-momentum portfolio returned an average of 21.94% a year. Here’s the chart:

Wow.
Also, while the momentum portfolios are more volatile, they don’t strike me as being usually high. The monthly standard deviation for the value-weighted momentum stocks is about 20% greater than the rest of the market. The equal-weighted stocks are 37% more volatile.
The problem I have with many small-cap or value-related models is that the results are highly cyclical. It’s true that small-caps do well after several decades, but it’s not unusual to see underperformance for five years of more. That happened to small-caps in the 1990s and I think value is entering a down phase right now. With momentum, the results are much more consistent. Heck, just look at the red and blue lines.
There’s also the question of what we mean by stocks with high momentum. I called Dr. French just to make sure I had it right and he was very helpful in explaining it to me. By momentum stocks, he ranks every stock by how it did over an 11-month period, then skips a month and then tracks them for one month. At the end of the month, the whole thing is repeated.
Confusing?
He’s an example. On January 1, we take the top 10% of stocks by their performance for the previous January 1 through November 30. The stocks are held for exactly one month and the process is repeated again on February 1.
This system in completely mechanistic and all emotions are banished. I’ve known lots of people who are momentum investors but they rarely have the discipline to act by strict rules.
Another interesting aspect of a momentum strategy is the turnover probably isn’t that high. Since it encompasses the best returns for 11 months, many stocks will remain each month. Dr. French said that he thinks the turnover is 91%. That’s high, but not as high as many mutual funds.
There are lots of historically interesting strategies but many are very impractical. For example, the stock market has been net down on Monday, Tuesday and Thursday combined. But it’s highly impractical to sell all your stocks and buy them a few times each week. But I don’t think that’s the case with a momentum strategy. Also, I’m sure you could even use ETFs to mimic the high-momentum portfolios.
There’s also the question of why. Why do stocks with high momentum continue to outperform for a bit more? Is there something inefficient in their…frothiness? Can a person really play the height of their frothiness all the time by constantly shifting?
According to the Efficient Market Hypothesis, this outperformance would rationally be exploited away. I’m not a believer in efficient Market Theory (ironically, it was developed by Eugene Fama) but I do think stocks show a bias towards efficiency. Perhaps there’s something in a surging stock that causes the pre-requisites for an efficient market to break down (flow of information??).
Dr. French was careful to say that he’s not the discoverer of momentum premium. That award goes to Jegadeesh and Titman who in 1993 found that the best-performing stocks of the last six months outperform the worst over the six to twelve month. I’m very impressed. I’m planning to look into more of the academic literature.

2008 Buy List
Posted by Eddy Elfenbein on December 5th, 2007 at 12:39 pm

I’ll unveil the Buy List for 2008 on Monday, December 17. I’ll start tracking the new stocks on January 1 and use the December 31 close as my buy price. I do this so no one can claim that I have any impact on the shares.
There are also two more earnings reports before the end of the year. FactSet Research Systems (FDS) reports on December 13 and Jos. A Bank Clothiers (JOSB) reports on December 18.

Gold and Iran
Posted by Eddy Elfenbein on December 5th, 2007 at 10:41 am

I’m curious how much the National Intelligence Estimate’s report that Iran suspended its nuclear program four years ago will affect the price of gold. While gold is impacted by inflationary concerns, it’s also influenced by geo-political concerns as well.
I suspect that problems with Iran have helped boost gold, but I wonder how large the impact has been. When gold is priced in euros, its rise hasn’t been as dramatic, but it’s certainly higher.
I’m also curious if the surge in support for Ron Paul is a sign of a top for gold. When gold peaked 28 years ago, the Libertarians had their best presidential showing ever. That year, Ed Clark won close to a million votes, including 11.66% in Alaska. The Libertarians even won two statehouse seats in Alaska that year. Double-digit inflation and gold at $850 seem to be very good for the party.
Since 1980, however, the Libertarian presidential candidates have been lucky to get half what Clark did. Now Ron Paul is running in a perfect environment for Libertarians—gold is up, the dollar is way down. The crucial primary will be in New Hampshire, a state almost tailored-made for them (“Live Free or Die”).
If Paul breaks 10% in New Hampshire, then I think gold will soon plunge. And no, I’m not serious.

Headline of the Day
Posted by Eddy Elfenbein on December 4th, 2007 at 3:44 pm

Countrywide CEO backs Fannie expansion

Reader Q&A
Posted by Eddy Elfenbein on December 4th, 2007 at 1:53 pm

I always like getting e-mails from readers. I get a lot so I try to respond to as many as I can. Please feel free to e-mail me if you have any questions or comments. If I do post you e-mail, I will not include your name.
Here’s a recent e-mail I got. I’m posting it because it’s a good question and slso because my responses kept getting bounced.

I am a frequent reader of your blog and have enjoyed many of the entries. Your investment style appears sound and a handful of your tips and articles have been quite conducive to my financial situation. Thank you. I have a question for you. I would like to find a fairly simple means of playing a rally in the US dollar. It may be versus a basket or a particular currency, for example, the euro. This may not be your cup of tea and so a simple ‘I do not know’ will suffice. If you have an opinion please email me at this address.
Thanks for the kind words!
You’re in luck! There is a simple way to play the U.S. dollar. PowerShares has an exchange trade fund that tracks the dollar. It’s the PowerShares DB US Dollar Index Bullish (UUP).
Here’s the description from Yahoo Finance:
The investment seeks to track the price and yield performance, before fees and expenses, of the Deutsche Bank Long US Dollar Futures Index. The index is comprised solely of long futures contracts. The futures contract is designed to replicate the performance of being long the US Dollar against the Euro, Japanese Yen, British Pound, Canadian Dollar, Swedish Krona and Swiss Franc. The fund is nondiversified.

Next Week’s Fed Meeting
Posted by Eddy Elfenbein on December 4th, 2007 at 12:30 pm

The Federal Reserve meets again next Tuesday and Wall Street expects another rate cut. According to the latest from the futures market, Wall Street thinks there’s about a 60% chance for a 0.25% rate cut and a 30% chance for a 0.50% rate cute.
I think the Fed erred last time by only cutting by 0.25%, and I would prefer to see the Fed cut by 0.50% this time. Unlike a lot of folks, I don’t think it’s absolutely critical for the Fed to get it exactly right all the time. Twenty-five basis points isn’t that big a deal in an economy this large. Still, the market needs some relief.
The odds of a recession have clearly increased over the past few weeks. Three months ago, Wall Street was expecting fourth-quarter earnings growth of 8.8%. Today that number is down to just 1.1%. Also, economically cyclical stocks have underperformed the market since July. I think that will continue.
It’s hard to overstate the importance of interest rates on stock prices. A few weeks ago, I looked at all the data going back to 1962. If you took all the days when the three-month T-bill rate fell, the S&P 500 rose over 2,000%. On days when rates rose—a nearly identical time frame—the S&P lost nearly 60%.

The Worst Columns on Subprime
Posted by Eddy Elfenbein on December 3rd, 2007 at 12:30 pm

Garrison Keillor now moves into second place for worst subprime column.

I sit in wonderment at the story of W. Lance Anderson, the president of NovaStar Financial in Kansas City, who while handing out subprime mortgages to any applicant wearing shoes and a shirt managed to sink the company’s stock from $40 in June to $1.72. This is a man who earned $1.7 million in salary and bonuses last year, plus $711,386 in deferred compensation, plus more dough in various arrangements that dopes like me can’t quite grasp. Meanwhile, all the little investors in NovaStar are cutting back on Christmas gifts and canceling their winter vacations in Daytona Beach.
I myself would never invest money in a company headed by a man named W. Lance Anderson. The very name inspires distrust. What’s the W for? Wolfgang? Whoopee? Weasel? A man who goes by W. Lance is likely to wear tinted glasses and two-toned shoes, smoke Kools, and have a gun fetish. Nonetheless, a small army of hopeful investors bought into the idea that you can make money on bad loans and now they are left holding the bag while W. Lance goes on to his next great idea, perhaps a scheme for making purses from dog poop, and I wish him and his family well, but I will not be there for him at the IPO.

Purses from dog poop! Get it? No one wants a purse made out of dog poop! Comic gold, Garrison.
I wonder if the 85% of subprime borrowers who are doing just fine see their lenders in quite the same way.
This is all part of the normal cycle. Someone freaks out about redlining. Soon, something must be done. Aggressive lending is encouraged. Then suddenly, someone freaks out about predatory lending. Again, something must be done.
If you’re curious, the worst subprime article award goes to Jim Rokakis, the treasurer of Cuyahoga County, Ohio. In a truly revolting article, he blames the death of a little girl and an elderly man on predatory lenders.

Twenty years ago, the Slavic Village neighborhood of Cleveland was a tightly knit community of first- and second-generation Polish and Czech immigrants. Today, it’s in danger of becoming a ghost town, largely because a swarm of speculators, real estate agents, mortgage brokers and lenders saw an opportunity to make a buck there.
You could say it was because of them that 12-year-old Asteve’ “Cookie” Thomas lost her life on Sept. 1, shot in Slavic Village when she stumbled into the crossfire of suspected drug dealers.

No, you can’t say it was because of them. You could, however, blame her death on the suspected drug dealers who fired at her.
Someone should tell Mr. Keillor that there are apparently lots of things made out of dog poop these days.

Is a Falling Dollar All Bad?
Posted by Eddy Elfenbein on December 3rd, 2007 at 10:45 am

Tyler Cowan had an interesting article in the New York Times on Friday saying that a lower dollar isn’t all bad for the economy. He’s right. There are lots of good things that come from a weaker currency. For starters, it generally helps a country’s export sector.
Matthew Yglesias looks at the issue from a social justice standpoint and sees some benefits. Personally, I’m a bit leery of a country trying to devalue its way to prosperity, particularly because it involves picking winners and losers.
Of course, the currency is always being manipulated in some form, but I still don’t see how Treasury officials can better investors than the market. A lower dollar isn’t too much of a surprise given that our national debt is growing by $1 million a minute. I think when you get right down to it, people don’t like the idea of their currency getting pummeled on the world stage. It just looks bad.
Cowan writes:

But from a broader perspective, the value of the dollar hasn’t fallen quite as much as it might seem. Since President Bush started his second term in January 2001, to Nov. 20 of this year, the dollar has dropped 19.8 percent — if we weight the dollar by how much America trades with individual countries. That is a noticeable decline, but it is hardly a radical economic event. There are still many bargains, travel and otherwise, in Asia and Latin America for people paying in dollars.
A falling dollar does mean price inflation in the United States. Just as it costs more for an American to buy a fancy meal in Paris, so do French wines and German cars have a higher markup when they are sold in New York. But imports are only 16 percent of the American economy, and most foreign suppliers have been reluctant to risk their position in the American market by raising prices a great deal. Furthermore many price increases from Europe come on luxury goods and thus they fall on wealthy American buyers, who can afford it most easily. Wal-Mart serves a more working-class clientele and it is stocked with goods from Asia, where currency values have remained weaker against the dollar.

Of course, one of the benefits of a lower dollar is it allows certain lobbies to bitch and whine. The head of Airbus recently said that the weak dollar is “life threatening.” Sure pal, I feel your pain. And while you’re at it, why don’t you try building a plane on time for a change.
The Wall Street Journal notes this morning that the dollar could be ready to rally:

But currency markets are hard to forecast, and there is a case to be made that the dollar could be near a bottom.
One argument: Comparing what a dollar now buys in the U.S. (at U.S. prices) and abroad (at foreign prices) suggests that the dollar is undervalued. “You can’t go to Europe and not think it’s really expensive, and a European can’t come to the U.S. and not think it’s for sale,” says Brad Setser, an economist at the Council on Foreign Relations.
The Organization for Economic Cooperation and Development calculates that $1 converted into euros could buy a basket of goods and services in France that would cost only 80 cents in the U.S. A dollar converted to yen would buy things that would cost 82 cents in the U.S. Over time, markets are expected to narrow such gaps by pushing up the dollar and pulling down the euro and yen.
Goldman Sachs economist Jim O’Neill says that by this measure, the dollar hasn’t been so undervalued against major currencies since 1995. “You don’t get these degrees of misalignment for long,” he says.

You don’t get these degrees of misalignment for long. But China wants to find out how long “long” is. Bloomberg also writes that a survey of economists expects a 7% rise for the dollar next year,
Almost exactly one year ago, I took a look at the dollar’s impact on the stock market:

The stock market has been freaked out lately due to the falling dollar, and the evidence shows that stocks prefer a strong greenback.
Since 1973, the dollar has risen on 4,189 days, fallen on 4,130 and stayed the same on 130. On the days of the higher dollar, the S&P 500 has risen a collective 2,356%, which is about 21.3% on an annualized basis.
On days of a falling dollar, the S&P 500 dropped over 55%, which works out to 4.8% on an annualized basis.
For the 130 days when the dollar is unchanged, the market is up 6.7%, or about 14.1% annualized.
Think of it this way, a weak dollar is basically the equivalent of a bear market for stocks.

Public Service Announcement
Posted by Eddy Elfenbein on December 2nd, 2007 at 1:25 pm

Best Science Article I’ve Read Today
Posted by Eddy Elfenbein on December 1st, 2007 at 12:15 pm

And the best science headline I’ve read all month:

Surfer dude stuns physicists with theory of everything