Rethinking Momentum

When I go looking for investment candidates to sell short, I am frequently drawn to securities or asset classes whose prices been driven beyond my perception of their fundamental value by "momentum" investors.

Momentum investing is merely the act of buying into assets because they're going up.  When speaking to investors who are drawn to the momentum style, the logic seems to be "if it's gone from 50 to 60, then maybe it's on its way to 80 or 100".  Many of them do not examine fundamentals at all.  As an investment style, it's bewildered me.  Instead of buying a security that's just gone from 50 to 60 in the hoped that it'll go to 80, wouldn't it be simpler to just find the next security that's going to go from 50 to 60?

I also seek out these sorts of momentum candidates because of the consequences we've seen in the past of momentum style investing.  The dot.com boom and bust was a consequence of momentum style investing, as was the recent collapse in real estate.  Shorting all the mortgage originators during the past couple of years has been an excellent way to make money betting against the momentum investing style.

But it doesn't always work so well.  And recently The Economist published an article, "Why Newton was wrong", extolling the virtues of momentum style investing:

http://www.economist.com/node/17848665?story_id=17848665&CFID=153742550&CFTOKEN=85693784

The performance differential is very impressive.  For any given year, an investor would enjoy an extra 12 points of returns if they had merely bought the best performing stocks from the previous year.  As the article points out, this is not a  new phenomenon.  This effect has been observable for much of the past century.

Will I adopt this strategy?  Absolutely not.  First of all, the article does not quantify the risk inherent in this strategy.  Furthermore, while the strategy works well for the best performers of any given one-year period, the strategy doesn't work so well for the best performers from longer periods, three years or more.  This would seem to reinforce the underlying logic to shorting momentum candidates in the first place:  Hot money has driven them to valuations that are irrational and unsustainable.  Finally, as the article points out at the end, it's momentum style investing that tends to create bubbles.  For those who rode the real estate boom and bust wave, many of them might have been rich in the middle of that cycle, but not many investors who played the long-side of that trade took their money and walked away at the top.

Most of them got clobbered when the bubble burst.

Still, this is a very useful study.  And for short sellers seeking out momentum candidates whose valuations have gotten out of hand, a more detailed look at the data could reveal some worthwhile information about timing an entry into a short position against a security that's been driven by the momentum crowd.