Momentum rules in a U.S. stock market stuck in worst rut on record

Stick with your winners, goes an old Wall Street adage - advice that is working better now than almost any time in the last quarter century.

Momentum stocks, or shares with the most price appreciation in the last two to 12 months, are rising three times as fast as the Standard & Poor's 500 Index in 2015, on par with the best years ever recorded. In a market stuck in the tightest trading range ever measured, industries like biotech and online retailers are posting gains of 30 per cent or more.

Investors are drawing greater distinctions among companies when S&P 500 profit growth is forecast to slow to 1 per cent, down from an annual rate of 15 per cent since 2009. Health-care and makers of non-essential consumer goods, whose earnings are expected by analysts to rise about 11 per cent this year, are in, while energy producers are out.

"As we get later and later in the recovery, people become more willing to chase momentum," said Craig Callahan, president at Icon Advisers Inc. in Greenwood Village, Colo. His firm oversees $2.5-billion and uses quantitative models to guide investments. "One thing they're getting their arms around is whoever is growing the fastest."

ETF Assets

This has been the sweet spot for momentum in the past: a bull market that is maturing. While sounding obvious, betting on past winners is an established market philosophy that underpins stock selection for almost two dozen exchange-traded funds in the U.S. alone.

Since the first momentum ETF was introduced more than a decade ago, the group's assets have grown to almost $5-billion, data compiled by Bloomberg show. The Powershares DWA Momentum Portfolio and iShares MSCI USA Momentum Index Fund are the biggest, with $1.9-billion and $725-million, respectively.

"More people are recognizing that momentum is a good long- term source of return, an important source of return in combination with, in particular, value," said Ronen Israel, a principal at AQR Capital Management LLC, which oversees $136 billion in Greenwich, Connecticut. "But there is little evidence to suggest it's getting over-crowded or there are too many people doing it."

The S&P 500 was little changed at 9:45 a.m. in New York, hovering within 5 points of an all-time high reached in May.

Momentum Crash

Riding momentum alone can be dangerous because the strategy assumes yesterday's success will repeat, regardless of valuations or earnings growth, according to Gregg Fisher, founder and chief investment officer at Gerstein Fisher in New York. Investors chased winners to the 2007 peak only to see their favorite stocks blow up during the 2008-2009 crash.

"It's a classic mistake," said Mr. Fisher, whose firm oversees $3-billion and incorporates momentum in its investing process. "I would caution investors not to embrace this by itself in an extreme way. We have lots of evidence that shows momentum strategy works better when paired with other things," like value, he said.

Demand for growth has made health-care and consumer stocks more expensive than any other industries in the S&P 500. With price-earnings ratios above 23, their multiples exceeded the market by more than 20 per cent, data compiled by Bloomberg show.

While some view the momentum trade as a function of market cycles, others say its success now is simply the result of circumstances such as the rate of U.S. economic growth, the dollar's rally and the plunge in oil.

Embedded Bets

"For people who are investing in momentum, they have to be aware of the embedded macro bets they're taking," said Hong Li, head of quantitative strategy for U.S. equity sales and trading at Citigroup Inc. in New York. "When positions get much crowded, the risk is higher," he said. "Timing the turning point is difficult."

A strategy of buying stocks with the best history of price appreciation in recent quarters, such as Skyworks Solutions Inc. and Netflix Inc., while shorting the worst like Chesapeake Energy Corp. and Freeport-McMoRan Inc., has gained 15 percent this year, according to data compiled by Evercore ISI. It beat every other quantitative model, including those based on growth, valuation or company size. Such a performance has only happened two other times in 24 years of data, in 2007 and 1993.

That's a reversal from the early part of this bull market, when momentum lost money in the first four years and returned less than half the market in the next two.

"Whatever has worked is continuing to work - it's like a self-fulfilling prophecy," said Abhra Banerji, director of quantitative research at Evercore ISI in New York. The technique isn't without risks, he noted.

"Essentially, momentum stocks become expensive enough to underperform," Mr. Banerji said. "That's a little tricky to call."

Winning Strategy

Momentum is winning today because a lot of companies that had big years in 2014, from Allergan Plc to Walt Disney Co. and Apple Inc., are doing well again. The top three industries in the S&P 500 this year - retailers, health-care providers and biotech stocks - also led the market in the second half of 2014, rising an average 14 per cent.

At the same time, few market laggards are making up ground. Energy providers, automakers and raw-materials producers, the biggest losers from July to December, have all stayed down, falling at least 2.1 percent this year.

While the S&P 500 has not seen a single day where its year- to-date change, up or down, exceeded 3.5 per cent, the difference in return between the best and worst-performing industries is widening, reaching the highest level since the bull market began in 2009.

"Momentum is one of the simplest and by far the most popular strategies investors use, from more sophisticated institutional investors to retail," said Dubravko Lakos-Bujas, head of U.S. equity and quantitative strategy at JPMorgan Chase & Co. in New York. "The last two years have been a stubbornly upward sloping curve. It's been relatively low volatility. That type of market tends to fuel momentum."