The January 8, 2011 edition of The Economist Magazine (pps 10 and 69) discusses an investment phenomenon that we at this firm have long observed: the tendency of stocks that have gone up in price to continue to go up in price for the sole reason that they have gone up in price. If “the momentum effect” (the name for the phenomenon) sounds a tad circular, even commonplace, you understand why academics don’t write about it. It is not theoretically elegant. Indeed, the momentum effect flies in the face of the reigning investment orthodoxy, which is called “The Efficient Markets Hypothesis.” The latter theory holds that prior price activity has no predictive effect on future prices, and is highly mathematical and theoretically elegant. As I said, it has held sway ever since I got into the business in the early 1970s.
But reality keeps getting in the way. According to The Economist, market observers have commented on the momentum effect for the last 100 years or so, and notwithstanding academic opinion, the momentum effect has given birth to a school of investing called “momentum investing.” Among money managers momentum investing is enormously popular because it does tends to produce the best short-term investment performance results (let it be noted that money manager compensation is based on short-term performance). On the other hand, momentum investing does have its critics. Why? Momentum investing tends to contribute to bubbles and the resulting disappointments when they pop, as happened in 2008-9.
There is a corollary to momentum investing and it describes stocks that go down in price. As you might guess, these downward-headed stocks tend to continue to go down in price for the reason that they have gone down in price. Again, circularity, though this time in the opposite direction. The corresponding school, the flip side to momentum investing, is called “value investing.” Over longer periods of time, it tends to lead the performance parade, but it is hard on money managers. Yes, value investing tends to have the best long-term performance, but what good is that if all your clients quit?
Last year (2010) the stocks that did the best were the stocks that did the best the year before (2009), and the stocks that did the worst were the stocks that did the worst the year before. What about next year?
Some very good stocks have been going down for too long. Take, for instance, Abbott Labs, Johnson & Johnson, Intel and Microsoft. When good news breaks, it is dismissed, and the stocks languish. One thinks of Abbott Labs’ recent announcement that it would boost its annual dividend for the 39th year in a row. No matter: the stock grinds lower. Or take Intel: No. 1 in semiconductors, its stock is selling at 10.5 times earnings (the larger stock market sells at 14 times earnings), it has boosted its dividend and is increasing its share-buyback program by $10 billion and this year’s capital spending by $9 billion. It too languishes. I could go on in this vein. The larger point, though, is that these very good companies offer a lower-risk way to participate in the stock market, though at the cost of short-term performance while the market rallies. For a portion of our portfolios it’s a trade-off we would make.