Momentum and the markets
Over the last year, significant macro concerns have become the focus of discussion once again. Be it the risk of a hard landing in China (again), the high yield bond market (still) or concerns about European bank balance sheets (again and still) the conversation has again turned to the big picture. This has driven dramatic moves in stocks, indices and sectors and our funds have not been immune. However, when we take a step back to see what factors are winning in these markets, we get worried about the indices, but also very excited about the opportunities that are being presented to long-term investors, such as ourselves.
AAII survey, % of neutral investors
As can be seen above, with so much confusion about the big picture, we exited 2015 with a lot of complacent investors. Complacency, high valuations and macro uncertainty was a very bad mixture to enter 2016. As we have seen it has driven a lot of volatility, panic and confusion.
Throughout 2015, and into the beginning of 2016, we have seen a narrowing of market breadth: fewer and fewer stocks were driving the market higher. Scared and short term focused investors crowded into the same names (hedge funds of course but also ETFs are to blame – more on this another time). For 2015 as a whole, price momentum outperformed the overall market by over 30%, the second largest outperformance in the last 25 years and bigger than 1999 (28.2%)!
“To beat the market, just buy the winners” CNBC 1/26/16
Of course momentum does include a lot of traditional growth companies (we all have heard of FANG’s amazing 2015 performance), but these days it also includes a lot of “boring” businesses that people feel comfortable with – a certainty of low but consistent earnings growth. Many of the former “boring” businesses where we found tremendous value in five years ago are now trading at very high multiples, reducing or eliminating the margin of safety that attracted us to them in the first place. In both cases (boring and secular growth) the market is overpaying for the “certainty” of the growth potential and taking on significant valuation risk by doing so. By the end of 2015, the top 10% of momentum stocks were trading at a 50% premium to the market as a whole, a level we had rarely seen.
The momentum trade tends to work later in the cycle in these uncertain markets, where macro factors and systemic concerns drive volatile trading in the short run. After all, investors feel more comfortable buying what’s been working rather than going into the areas of the market that have been feeling the pain! But as you can see back in Fig. 1 it typically coincides with overall market peaks. Eventually the momentum trade ends, usually in a swift and dramatic fashion, with the group underperforming the overall market by 40%+ in a very short period of time.
It’s been a difficult year so far for a lot of investors, and our funds have not been immune to this. We have been fortunate to enter this year with a lot of cash and a long list of potential core holdings to add to the funds (at the right price), however there are a lot of simple/stable/boring businesses that are not offering attractive risk-reward anymore – these have become a source of funds and overall cash positions haven’t fallen dramatically. As the market is crowding into the previous winners, we are finding tremendous opportunities in the depressed areas of the market. While I don’t know what will happen over the next six months, and our concerns about China and high yield bonds remain, I am more excited about the opportunities I am seeing today than I have been in almost five years. Additionally, with our disciplined investment approach and expanded analyst team we are better able than ever to execute on these opportunities.