Momentum: A Crowded Trade

Interest rate uncertainty had little to do with the flat performance of the S&P 500 year-to-date. The main cause of a directionless market is a crowded momentum trade due to hype about the potential success of these simplistic strategies.

In the 1980s traders believed that they could compress market price action down to a few chart patterns and profit. The failures were massive because the market reacted as it should, transforming the charts patterns into pure noise. There was excessive hype as those of us who started trading during that time can remember. Books, articles, magazines, all devoted to the new dynamic way that promised wealth.

Instead the result was a massive wealth redistribution from technical traders to market professionals, mainly the specialists working on the stock market floors and pit traders in Chicago. I remember meeting a specialist who lived in a mansion in upstate New York with his three Ferraris parked in his garage. He briefly mentioned to me how the market was full of suckers and that one did not need education or quantitative analysis skill to become rich but only an understanding of how the market operates. I thought I got a good price for his wife’s Maserati, which he convinced me to buy at a good price because, as he said, it was too fast for her. After the purchase I found out that he has set up a bull trap for me because there was a difficult-to-fix problem with the twin turbos that did not synchronize properly. Never buy anything a floor specialist recommends, that was the lesson…

Nowadays, something similar to the old technical chart pattern hype is happening: momentum; cross-sectional, absolute or dual. Books, journal articles, magazines and social media messages have created hype about these strategies. The hype peaked early this year and the market naturally responded. Some analysts with a backtesting platform and limited knowledge of the markets do not realize that trading of any sort is a zero-sum game before expenses are taken into account. There is no way for a trader or group of traders to profit without some other trader or group of traders losing the same amount of money. It is simply impossible for that to happen because money is not created ex nihilo.

SPX_20151221

The massive adoption of momentum strategies, even in the form of ETFs, has caused the longest consolidation period in the recent history of S&P 500. Some thought that this was caused by interest rate uncertainty but the past shows that expectations about interest rates are discounted and the markets choose direction. The main cause of the long consolidation period was that momentum strategies kept driving valuations of some large cap stocks higher while value investors and mean-reversion traders kept selling those stocks. The result was a range-bound market, as shown in the above chart.

Last August, someone pulled the plug and the market crashed. This was a warning directed to momentum traders that they are involved in a crowded trade. However, the crash and death cross only offered more hopes to momentum traders and the hype continued. More books, more articles, more tweets about momentum strategies.

What is really momentum? It is in many cases the trivial strategy based on price level comparison. More complicated cases involve moving average crossovers and volatility adjustments for position sizing. That some people think they can outsmart other traders with such basic strategies and take their money is just mind boggling. The most plausible answer is that those who hype such strategies do not comprehend market structure and the law of action-reaction, i.e., the fact that for every action, there is a reaction. This did not apply in long-term backtests that are used to support the viability of momentum because the strategy was not used then and no one reacted to it. Now that the strategy is actually used extensively, it is slowly being neutralized by the market. The best way of neutralizing momentum is through extended whipsaw. This is what happened throughout this year.

If the golden cross that occurred in S&P 500 yesterday fails, this will add to losses of momentum strategies and possibly drive some ETFs and funds out of business. Simple edges do not last long, especially as soon as they are extensively traded. This was the case with several other anomalies in the past. Momentum will not be an exception but along the way of arbitraging this anomaly, returns from markets may be limited.

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