Momentum investing – buying stocks with the strongest recent price moves and earnings growth – has been among the top performing strategies for most of the post-financial-crisis rally.
But in a possible warning of intense equity market volatility to come, that strategy has broken down over the past month.
The FANG stocks – Facebook Inc., Amazon.com Inc., Netflix Inc., and Google parent Alphabet Inc. – have been the most visible successes for momentum investors in recent years, but other stocks such as Nvidia Corp. and Microsoft Corp. have also driven outperformance for the strategy.
The iShares Edge MSCI USA Momentum Factor ETF holds a portfolio of stocks weighted toward those with the strongest price momentum. The top holdings are Amazon, Microsoft, Visa Inc., Boeing Co., Mastercard Inc., and JPMorgan Chase & Co.
The momentum ETF has richly rewarded investors since its inception in September, 2014. The three-year average annual return of 16.7 per cent easily outdistanced the S&P 500’s average return of 11.9 per cent over the same period. But over the past month, the ETF’s 0.21-per-cent decline trailed the benchmark by a full percentage point.
Momentum investing is a proven strategy over the long term, but there’s a big caveat – the temporary portfolio punishment when it stops working is far more severe than for value or growth investors.
As Ian McGugan noted recently in Report on Business Magazine, if you practised momentum investing and rebalanced your portfolio every month, you would have achieved an impressive 11.8 per cent annual average return over the past 16 years. But here’s the catch: You would have lost nearly 64 per cent of your money in 2009 and not fully recovered your losses until 2014.
Netflix Inc., which opened lower by 14 per cent Tuesday after reporting disappointing quarterly results, is the ninth-largest holding in the momentum ETF. Netflix’s stock has endured deep downdrafts before in the past decade and then recovered strongly, but the price volatility provides a warning about what can happen when momentum stocks lose momentum: The bottom drops out.
Technology stocks have provided the lion’s share of gains for the S&P 500 in the first half of 2018, contributing 98 per cent of the total return according to Merrill Lynch chief quantitative strategist Savita Subramanian. This narrowness in the market rally – few companies responsible for almost all the upside – increases the downside risk to the overall index if the tech stocks currently showing upward momentum falter.
Narrow market leadership also means that investors holding S&P 500 index ETFs may be surprised about the extent of volatility if momentum stocks roll over.
It is by no means a foregone conclusion that the success of momentum investing is now over, despite Netflix’s travails. Investors should be aware, however, that the end of the road for momentum stocks, when it does occur, could be a painful ordeal for portfolios.
Scott Barlow, Globe Investor’s in-house market strategist, writes exclusively for our subscribers at Inside the Market.