15 Lies About Trading And Investing– Lie 8
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Lie 8: Stock Market Momentum Is A Robust Anomaly
Momentum became a popular buzzword in the past few years due to books, academic papers and blogs. The basic claim is the momentum is a robust anomaly because it has persisted for a long time as backtests show and therefore it will continue delivering high risk-adjusted returns to stock market investors.
There are two basic types of momentum: relative and absolute.
Relative momentum, also called cross-sectional momentum, is the anomaly that has allowed outperformance on a risk-adjusted basis when buying securities that outperform and selling those that underperform.
Absolute momentum, also called time-series momentum, is the anomaly that has allowed outperformance on a risk-adjusted basis when buying securities with a positive return and selling securities with a negative return.
Therefore, momentum, relative or absolute, is a trivial strategy that is based on price level comparisons. It is often combined with moving average crossovers for timing and with volatility adjustments for position sizing.
It is quite peculiar that some think that they can use trivial strategies and profit consistently in the longer-term. However, long-term backtests reinforce this belief.
Note that momentum investing proponents usually make references to academic papers that support their beliefs while ignoring those that do not. Below are two papers that provide an opposite view:
(1) Have Capital Market Anomalies Attenuated in the Recent Era of High Liquidity and Trading Activity? Torun Chordia et al., March 2014 (Link)
In this paper it is shown that returns from all market anomalies have decreased by about 50% in recent years.
(2) The Disappearance of Momentum, Soosung Hwang and Alexandre Rubesam , November 2013 (Link)
In this paper it is shown that “… momentum profits have slowly disappeared since the early 1990s, in a process which was delayed by the occurrence of the high-tech and telecom stock bubble of the late 1990s.”
The main reason that the momentum anomaly has persisted for so long is that it has not been arbitraged out of the market yet due to low participation (not too many believed in it) and also lack of trading discipline. It is also quite possible that robo-advisor and algo trading domination will cause the momentum anomaly to disappear in the future. This has already started with micro-momentum disappearing from daily data, as shown by the 1-lag autocorrelation of S&P 500 returns:
The 1-lag, 252-day correlation of arithmetic returns and the bands for 95% confidence are shown in the above chart. The autocorrelation was positive and significant during in the 1950s and up to the mid 1980s. Then, by the mid 1990s positive autocorrelation was replaced by negative. The stock market exhibits mean-reversion tendency since the mid 1990s and this is the main reason for the large swings.
Technical analysis was developed during a period of high positive autocorrelation and it is entirely possible that its inventors were fooled by these special market conditions shown on the above chart and thought that some patterns and indicators had forecasting power. In reality, during times of high autocorrelation, breakouts in the direction of an uptrend or downtrend were in most cases valid continuation signals. However, when momentum was replaced by mean-reversion, reversals followed the breakouts. That had a massive adverse effect on retail traders who were following technical rules and a large percentage of them lost their money.
The switch from momentum to mean reversion is also shown by the swings in the Momersion indicator:
When the Momersion(250) indicator is below the 50% line, price action is dominated by mean-reversion and when it is above it, it is dominated by momentum.
The real danger for momentum investing is a prolonged period of momersion, i.e., frequent changes from momentum to mean-reversion and vice versa. This is already happening and it is one reason that momentum strategies have ceased to outperform.
Therefore, the claim that momentum is a robust anomaly is a lie. In the best case, one could claim that momentum is an anomaly that has survived over the years but this is unlikely to continue for much longer, especially now that it has become popular and there are many funds and ETFs that depend on it.
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