Momentum in prices can be described as the tendency of assets that performed well over the prior year to continue outperforming assets in the same asset class that have performed poorly over the prior year. This phenomenon has been found to exist not only in stocks all around the globe, but in bonds, commodities and currencies. And it has generated large—though highly volatile—returns.
The persistence and pervasiveness of the momentum anomaly in stocks led Nobel Prize-winning University of Chicago professor Gene Fama to call momentum the greatest challenge to the efficient markets theory. It’s hard to construct a risk-based explanation for the anomaly other than that it is subject to crashes.
In his February 2015 National Bureau of Economic Research paper—“Fundamentally, Momentum is Fundamental Momentum”—University of Rochester professor Robert Novy-Marx presents evidence demonstrating that momentum in stock prices isn’t an independent anomaly. Instead, it’s driven by fundamental momentum.
According to Novy-Marx, stock price momentum is “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.” The following is a summary of his findings:
- Momentum in company fundamentals (earnings momentum, for example) 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 regression of returns analyses on firm characteristics. In addition, the time-series performance of price momentum strategies is fully explained by their covariance (a measure of the degree to which two random variables change together) with earnings momentum strategies. The data was statistically significant at the 5 percent 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. It also 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 exhibit Sharpe ratios twice as large as the already-high Sharpe ratios observed on their conventional counterparts.
Novy-Marx’s paper makes an important contribution to the literature on the momentum anomaly in stocks and provides a valuable insight. His research indicates that with equities, there could be a better way to exploit the momentum anomaly than through using a price-only momentum strategy. It will be interesting to see if this research gets incorporated by fund families.
Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.