by Ryan W. Smith
Two of the most popular trading strategies have seemingly gone head-to-head for decades with no clear winner in sight. Research has also not proven out a clear winner between Momentum Trading and Value Investing, leading many in the industry to wonder if either is a viable long-term prospect alone. It might surprise many to learn that, like most things in life, balance and moderation are the keys and many in the industry are starting to combine these two trading strategies.
Momentum Trading is an approach in the investment world where traders will only concern themselves with the “hot picks” of the day, the high percentage and volume movers of that trading session. Traders in this methodology will look for assets that move a significant percentage on a given day, in high volume. This trading strategy is not a long-term or buy-hold type of strategy. Instead, traders will hold their long or short positions for only as long the stock is moving quickly, which can be a few hours, a few days or just a few minutes.
To be successful, momentum traders must exercise abundant patience. They must remain steadfast as a stock moves in the direction they want, but their target has not yet been reached. Will it get there? Have they chosen poorly? This quasi day-trading strategy is one that, for certain, will have results which vary widely day-to-day. It is important to note that momentum trading is not the same thing as “trend trading,” which looks for swing trades that will also utilize momentum in a given direction, but its moves are measured in weeks, not hours, as the market “swings” in a given direction.
Momentum trades are very short in duration, and those positions held longer than a week typically fall into the “swing trade” category, a strategy that has been utilized by many in the industry in the months following the 2016 election as nearly all U.S. markets have risen to record highs.
Value Investing, on the other hand, is definitely more of a medium to long-term prospect. Value investors are specifically looking for undervalued assets that traders believe are currently priced below their intrinsic values. Investors who employ this strategy believe strongly that the market overreacts to both good and bad news.
To be successful, value investors are looking at the intrinsic value of a stock and believe that an overreaction has caused the market value and intrinsic value of the asset to diverge. Value investors try to take advantage of the disequilibrium created by these overreactions, typically looking for lower-than average price-to-book ratios, lower-than-average price-to-earnings ratio or higher dividend yields. The real difficulty in value investing is determining the intrinsic value of a stock.
This is why a high percentage of value investing activity will occur around the release of a quarterly earnings reports where overreactions can provide opportunities to buy or sell assets in disequilibrium. In many instances a company’s earnings release will be met with strong selling or buying that appears to be counter to their actual report or far more intense than the numbers appear to warrant. A value investor might determine that a 30% drop in a stock’s price immediately after releasing earnings that mostly met expectations present such an opportunity to go long the stock. That value investor might take a look at guidance for the next quarter and year, whether the stock had a strong positive run in the weeks before the earnings release that might warrant profit-taking or whether there was another mitigating factor for that industry or company that superseded any earnings news.
One item that makes value investing a bit more complex than momentum trading is that there is no standard methodology to employ, the strategy is completely subjective. Some value investors will only look at present assets without regard to future growth prospects. Others will only construct their value components from future growth prospects and cash flows. Differences aside, value investors are almost always buying something for less than what they believe it to currently be worth.
The climate immediately following the 2016 election was one where exceptions were made in this regard, many in the industry have said, and value investors were buying assets near 52-week or all-time highs because their information pointed to higher highs and clearer market conditions going forward. That is, despite being near their peaks, these investors still believed the current price was below in the intrinsic value of the asset.
Momentum trading on the other hand, is perpetually only seeking alpha, the excess returns on an investment in relation to its benchmark. Finding a value trade can, in fact, be a momentum trade as well given the high sharp ratios present in many “good deals.” A key difference, however, is that a momentum trader would most likely sell much more quickly than a value investor who made a similar investment around the same time. Momentum traders are looking for positive sharp ratios, positive alpha and quick returns, which can also be present in investments that value investors might buy and hold for years.
Both momentum trading and value investing are subject to certain pitfalls that many in the industry claim justifies a belief that one of the best strategies available to investors is a blend of these two methods. Sometimes an asset is a “value” for a reason and value investors could very well wind up holding an asset that continues a downtrend after an investment is made, the very definition of the trading term “bag holder.” In instances like these, moving out of an asset quickly, like a momentum investor who misjudged the momentum of a security, could prove to be prudent. The most important aspect of investing, many successful advisors say, is timing.
Research into momentum trading and value investing has increased in recent years, because of the inherent philosophical differences and the negative correlation of the two methods that appears to occur across most market conditions. There is some overlap, as mentioned above, but there is ample evidence of this negative correlation. For example, in the dot-com peak and bust of 1997-2001, value investing methods took substantial losses while momentum trading methods did not have losses nearly as pronounced. However, in early 2009, during the height of the stock market meltdown that was part of the Great Recession, it was value investing that held its own while momentum investing did very poorly.
The differences between these last two large-scale market sell-offs was in the recovery from their nadirs. As the market recovered from the tech bubble, momentum was the method which worked better due to the consistent movement up and down, price action that would go one way for a few days then the other way for a few more, time periods that were just too short for swing trades but were perfectly suited to momentum trading. In other words, the momentum was sustained in both directions as the market moved. In 2008-2010, however, the market’s recovery from its low point was disjointed with large fluctuations on a day-to-day, week-to-week, even hour-by-hour basis depending on the news cycle.
Conversely, when investors were trying to find value in the tech boom, many of the assets which looked promising were companies with serious questions about profitability and long-term viability, due to the nascent nature of the technology. Many of the assets, which rose so high, so quickly, did so on a promise of future profitability, not actual book value. These assets, which appeared to be a good value based on the difference between their 52-week highs and lows, simply did not have the sustained profitability to justify their lofty valuations and were not able to recover the valuations at their zenith.
In 2009, however, the entire market appeared to take a haircut off the top, leaving ample opportunity to find assets that declined far more than their actual performance would have dictated in regular conditions. These assets, in turn, were then able to continue being good values even as the recovery was extremely choppy.
Momentum and value investing are often viewed as polar ends of the same spectrum. Momentum trading is often looked at as short-time gains with higher trading costs, while value investing is often viewed akin to long-term buy and hold strategies. This characterization is both correct and misleading. Because both methods have been shown over time to capture positive alpha and Sharp ratios when employed effectively, each has value in its own right.
Oftentimes, a strong analytical program, like AdvisoryWorld’s SCANalytics software, can be utilized to show the differences between these two investment strategies over a given time period. This analysis can also show, quite clearly, that investors who subscribe solely to one of these two methods will eventually be disappointed. As with many things in life, balance and moderation is a key driver of success and there is great benefit in understanding one of the keys of investing no matter what method is employed: timing is everything.