A Different Look at Industry Momentum — II

There have been a lot of posts on the power of the momentum anomaly lately.  To mention two, there was my post, A Different Look at Industry Momentum, and a post by Mebane Faber at his excellent blog World Beta, Quantitative Strategies for Achieving Alpha.  I know there have been more recently, but somehow I did not bookmark them.

Tonight’s note considers whether the strength of the momentum effect might not be waning.  Consider this:

This graph shows the excess returns of my industry momentum model over the past twelve years.  Momentum has worked over that time period, but deceasingly so, with a few wipeouts along the way.  Many will remember the worst of them in August 2007, when quantitative investing was decidedly crowded.

Remember, I view investment strategies using an ecological framework.  There are many strategies that work on average, but often many of them are overpursued, and the excess returns have been competed away.  Or, a strategy has been forgotten, relatively speaking, and now it might have some punch.

I am guessing that momentum as a factor is overplayed at present, and it might be wise to leave it to the side until the next wipeout.  If that were to apply in the present market, it would mean the failure of the more stable parts of the market to retain value: consumer staples, utilities, health care, other cash flow spinning industries.

There are two ways that could happen: 1) a resurgence of the cyclicals, and 2) market collapse, where investors give up on all stocks, even stable ones.  I’m not going to bet on either of those, but either is possible in this environment.  If demand begins to rise in the world due to falling commodity prices, #1 is possible, and #2 would come from a continuing collapse in consumer demand.

Food for thought in this ugly environment. Invest carefully, the need for a margin of safety is more critical than ever.