The markets conjured grim visions of collapse and ruination as stocks tumbled into the end of February. The quick correction might be a mere panic attack or the harbinger of things to come.
Signs of a serious decline can be gleaned from the behaviour of momentum stocks, which often act like canaries in the market’s coal mine.
Momentum is known for doing very well in bull markets and then disintegrating in market crashes. I expected the first two months of the year to have served up a momentum massacre.
But, before diving into the numbers, it’s worth pointing out that most momentum strategies are shockingly simple. The basic idea is to buy stocks that have gained the most in recent months with the expectation they’ll continue to move higher in the short term. It’s a simple strategy that has worked well for decades and even centuries.
I explore the state of Canadian momentum by starting with the largest 200 stocks on the TSX by market capitalization. The momentum portfolio buys an equal-dollar amount of the 20 stocks with the highest total returns over the prior 12 months, holds them for a month, sells them and then repeats the process.
The momentum portfolio generated phenomenal long-term returns. It gained an average of 19.4 per cent annually over the 25 years through to the end of February, according to the Bloomberg back-testing tool. The Canadian market, as represented by the S&P/TSX Composite Index, gained an average of 8.2 per cent annually over the same period. (All of the returns herein are in Canadian dollar terms and are based on monthly data through to the 28th of each month. They include dividend reinvestment, but do not include taxes, trading frictions or inflation.)
The momentum portfolio’s returns would have been lower in practice owing to the costs and frictions caused by monthly rebalancing. It would also have needed a good deal of effort to maintain over the years. Perhaps most importantly, sticking with momentum would have been murderously hard.
Problem is, there were 14 months when the momentum portfolio fell by more than 10 per cent. The crashes of 2000 and 2008 were horrific.
In 2000, the momentum portfolio lost 7 per cent in March, 38 per cent in April and 24 per cent in May. Just imagine sticking with the portfolio after that string of losses. Most investors would have given up. In total, the portfolio fell almost 60 per cent from its early 2000 high to its 2001 low.
Similarly, the 2008 crash saw a 16 per cent decline in September, followed by a 34 per cent decline in October. The portfolio gave up 51 per cent from the top in 2008 to the low in early 2009.
You can see the power of negative momentum in the accompanying graph.
That brings me to the experience of recent months, which – contrary to my expectations – wasn’t that bad. Yes, the momentum portfolio fell, but it gave up just 1 per cent in January and 6 per cent in February. While the declines might be a precursor of worse things to come, they weren’t unusually bad ones for the method.
The momentum portfolio, shown in the accompanying table, currently contains a heavy dose of gold and precious metals stocks, which might provide a buffer against further market declines. Time will tell.
While the momentum canary hasn’t given up the ghost in Canada quite yet, I’ll be keeping an eye on the little fellow. But I hope the new coronavirus will prove to be milder than expected and short-lived. I wish everyone good health and good fortune in the months to come.
Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com.