Swedroe: Momentum Rooted In Earnings

December 15, 2017

Momentum in prices is the tendency of assets that have performed well recently (such as over the prior year) to outperform assets in the same asset class that have performed poorly recently. This phenomenon has been found not only in stocks all around the globe, but in bonds, commodities and currencies. Furthermore, it has generated large—though highly volatile—returns, and it’s also subject to crashes.

The persistence and pervasiveness of the momentum anomaly in stocks led Nobel Prize-winning professor Gene Fama to call momentum the greatest challenge to the efficient markets theory—it’s hard to construct a risk-based explanation for it (other than it is subject to crashes).

That said, as my co-author Andrew Berkin and I explain in our book, “Your Complete Guide to Factor-Based Investing,” the academic research has provided evidence of some possible risk-based explanations: Momentum is stronger among stocks with large growth opportunities, and risky cash flows and liquidity risk can explain at least part of the phenomenon.

Momentum & Earnings

In his February 2015 NBER working paper, “Fundamentally, Momentum Is Fundamental Momentum,” Robert Novy-Marx presented the evidence demonstrating that momentum in stock prices isn’t an independent anomaly. Instead, it’s driven by fundamental momentum.

Specifically, he writes, it’s “a weak expression of earnings momentum, reflecting the tendency of stocks that have recently announced strong earnings to outperform, going forward, stocks that have recently announced weak earnings.”

Following is a summary of Novy-Marx’s findings:

  • Momentum in firm fundamentals, e.g., earnings momentum, explains the performance of strategies based on price momentum. It holds for both large and small stocks.
  • Measures of earnings-surprise subsume past performance in cross-sectional regressions of returns on firm characteristics, and the time-series performance of price momentum strategies is fully explained by their covariances (a measure of how much two random variables change together) with earnings momentum strategies. The data was statistically significant at the 5% level
  • Controlling for earnings surprises when constructing price momentum strategies significantly reduces their performance, without reducing their high volatilities.
  • Controlling for past performance when constructing earnings momentum strategies reduces their volatilities and eliminates the crashes strongly associated with momentum of all types, without reducing the strategies’ high average returns.
  • Earnings momentum subsumes even volatility-managed momentum strategies. Price momentum strategies that invest more aggressively when volatility is low have Sharpe ratios twice as large as the already-high Sharpe ratios observed in their conventional counterparts.

Issue Of Acceleration
Novy-Marx’s findings are consistent with those of Shuoyuan He and Ganapathi Narayanamoorthy, authors of the October 2017 study “Earnings Acceleration and Stock Returns.” They examined the implications of earnings acceleration for future stock returns.

Their data sample included almost 380,000 observations, spanning more than 8,800 different firms and 176 fiscal quarters over the period 1972 through 2015. They defined earnings acceleration as the change in earnings growth from one quarter to the next, and earnings growth as the scaled change in earnings over the corresponding quarter the previous year. Following is a summary of their findings:

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