A Different Look at Industry Momentum

Since 1996, I’ve been aware of research that indicates that momentum works in the stock market.  My quandry as a value investor has been to figure out how to incorporate it, if at all.  My approach was to play for the weaker mean-reversion effect, and have a lower turnover rate than would be needed in a value plus momentum strategy.  I am now questioning that decision, even though I have done well in the past. I just finished the initial stages of an analysis that will be available to my clients highlighting the value of momentum strategies.  Using the industries in the S&P 1500 Supercomposite, from October 1995 to December 2008, investing in the Supercomposite yielded an annualized price return of 4.0% (with dividends 5.5%).  The annualized price return for each momentum quintile, where momentum was defined as return over the previous 200 business days, was as follows:

  • Top — 11.3%
  • Second — 4.4%
  • Middle — 6.5%
  • Fourth — 1.7%
  • Bottom — 0.2%

Now, there are several weaknesses with this analysis:

  • No trading costs.  (I think those could be minimized.)
  • Some industry groups are small, and could not accommodate a lot of money.  (Probably a large problem)

That said, even with those difficulties, there should still be some excess return from following a momentum strategy.  What industries would that imply at present?

  • Education Services
  • Brewers
  • Biotechnology
  • Water Utilities
  • Insurance Brokers
  • Environmental and Facilities Services
  • Hypermarkets & Supercenters
  • Health Care Services
  • Packaged Foods
  • Pharmaceuticals
  • Gold
  • Multi-Utilities
  • Restaurants
  • Tobacco
  • Household Products
  • Home Improvement Retail
  • Food Distributors
  • Distillers & Vintners
  • Reinsurance
  • Food Retail
  • Integrated Oil & Gas
  • Health Care Technology
  • Airlines
  • Health Care Supplies
  • Electric Utilities
  • Distributors

For a quick summary, think staples, utilities, health care (excluding insurance), and other industries with stable cash flow.  This is about as bearish as it gets, so be careful for now, and don’t speculate on when the turn in the economy will come.  Focus on what consumers always need. Or, as James Grant once said (something like), “Could this be a bull market in cash?” ;)


  • matt says:

    Mr. Merkel:

    There is a book by O’Shaughnessy (or something like that) called “What works on Wall Street.” In it, he creates a hybrid strategy based on several value ratios and relative strength over differ lengths of time. It had fantastic risk adjusted returns (and overall returns).

  • Hi David, I have enjoyed the benefit of your writing and analysis for many years. Our fund is based upon Soros’ theory of reflexivity, which I believe is the main cause (along with some behavioral inefficiencies) of the persistency of the momentum effect.

    A change (could be macro, sector, or company-specific) occurs at a company that triggers a feed-back loop between the stock price and the company fundamentals. Another way of looking at it is through the idea of “real options”. Certainly a company whose stock has gone up has a lot more “real options” than one that has declined. Now the management may ultimately use those options to destroy value, thus triggering a negative reflexivity cycle but in the interim, the equity value of a company with more “real options” should be worth more than a company with less.