Andrew Haldane is an economist at the Bank of England who writes some of the most interesting stuff available on the (mis)behaviour of the financial sector, and I recommend his recent speech on Patience and Finance. This argues that patience (or long-sightedness) is an economic virtue, the exercise of which should lead to faster GDP growth, higher returns to fund managers, and a sounder financial system. However, the part of his speech which I found most fascinating seemed to contradict this conclusion. This is an assessment of investment strategies which are based on momentum in asset prices, rather than long term economic fundamentals. Momentum wins the race hands down.
Andy Haldane conducts the following experiment. He estimates the results of an investment strategy in US equities which is based entirely on the past direction of the stockmarket. If the market rises in the period just ended, the strategy buys stocks for the next period, and vice versa. In other words, the strategy simply extrapolates the recent trend in the market. The result? According to Andy, if you had been wise enough to start this procedure with $1 in 1880, you would have consistently shifted in and out of stocks at the right times, and you would now possess over $50,000. Not bad for a strategy which could have been designed in a kindergarten.
Next, Andy tries an alternative strategy based on value. This calculates whether the stockmarket is fundamentally over or undervalued, and buys the market only when value gives a positive signal. The criterion for measuring value is the dividend discount model, first devised by Robert Shiller. If you had been clever enough to devise this measure of value investing in 1880, and had invested $1 at the time, the procedure would have left you with a portfolio now worth the princely sum of 11 cents.
I am sure that fundamentalists will argue that this particular value strategy is far too simple, and that other ways of using the Shiller p/e or alternative measures of value would produce much better results. That may be the case, but it does not detract from the fact that a very basic momentum-based technique seems to work very well indeed. And that should not be true if you believe in the efficiency of capital markets.
The Haldane results are far from the first to establish the puzzling fact that the past behaviour of asset prices tends to predict the future. Some traders may not see this as puzzling at all, since they have always made money by extrapolating trends. But the efficient market hypothesis (EMH), taught in every business school, emphatically says that nothing which has happened in the past, and which is widely known to the market, should be able to predict the future path of asset prices. Why not? Because as soon as such information is published, it will be absorbed into the price, and that price will subsequently change only when new (unforecastable) information comes along.
Much investigated, and frequently derided, the EMH has actually been very hard to disprove. But surely the past behaviour of the stock-market is the single most widely known piece of relevant information, not just among market professionals, but among dentists, taxi drivers, Uncle Tom Cobbley and all. If that simple piece of information can predict the future course of the market, then how can the EMH possibly be true?
I can think of only one way. Perhaps portfolios which are based on momentum produce higher returns than other strategies because they involve taking greater risk. The EMH would have no trouble with this – higher risk should produce higher returns. It is possible that momentum-based strategies involve greater risk because they are always entering “crowded” trades after many market speculators are already in the trade. When these momentum-driven trends change direction, the losses can be very sudden and very large, because so many active traders head for the exit at the same time.
This seems a possible explanation, but it is not fully persuasive. After all, it is quite possible for portfolio managers to hedge themselves against large losses when they run momentum strategies. Even after allowing for the costs of these hedges, momentum seems to earn abnormally large profits in many types of assets, over many periods of time. And that is why quant investors usually include these procedures in their funds, albeit in a more sophisticated form than the simple method described above.
So if you have any sympathy at all for the EMH, you should find the apparent success of momentum strategies puzzling.
Puzzling, but remunerative.
Related reading:
Seize the moment, not the momentum- John Authers, FT
When Are Times Right For Momentum Investing? Mark Hulbert, Barron’s
