By Matthew Haupt
With global uncertainty well above normal levels, momentum strategies should be underperforming – yet they are not. Here’s why.
Momentum trading involves buying yesterday’s winners and selling yesterday’s losers. To trade momentum is to find wisdom in crowds.
This can be the right strategy if an individual investor believes that the crowd has better information or superior information processing capabilities than themselves.
Commonwealth Bank, Pro Medicus, Wesfarmers and Telstra are a handful of stocks that exemplify the momentum trade in Australia.
History suggests that following momentum in the Australian sharemarket works more often than not. However, we are sceptical that momentum will be a winning strategy over the next 12 months. More importantly, we believe that investors need to be aware of the risks they are taking if they are positioning for momentum to continue.
Momentum is often a strategy used to navigate bubbles. To be clear, we doubt that investors need to completely avoid bubbles – but at the very least, they must understand the game they are playing.
If an investor is unaware of the risks or does not realise their part in the game, they are vulnerable. In a bubble, the real danger is not just the eventual crash – it is that most participants never see it coming.
They get swept up in the momentum, mistaking rising prices for real value, and by the time reality hits, it is often too late to get out unscathed.
Momentum stocks have performed remarkably well since Liberation day. We say remarkably, not just because these stocks are outperforming, but because it is very unusual for momentum strategies to succeed when uncertainty is high.
From a macro perspective, momentum strategies require the profile of yesterday’s winners and losers to resemble tomorrows as closely as possible. However, this requires a relatively stable macro environment with low uncertainty, enabling households, corporates and investors to leverage up.
Indeed, the use of leverage can prolong cycles, contributing to ongoing momentum – to the extent that there is some cyclicality to it. Conversely, momentum tends not to work around major turning points in the cycle, when uncertainty typically spikes higher and when the combination of high uncertainty and funding stresses can cause de-leveraging.
Our preferred indicator of global uncertainty uses signals from bonds, equities and the news flow. Back-testing suggests that when global uncertainty is well above normal levels, momentum strategies tend to underperform in the subsequent period.
Right now, uncertainty is well above normal levels – in fact, it has remained elevated ever since Liberation day back in April. Momentum strategies should be underperforming, yet they are not.
A sophisticated approach
The main reason for this is that high uncertainty has not caused funding stress, nor has it triggered significant de-leveraging. Notably, in the US, hedge funds continue to lever up to buy bonds via key banks or primary dealers.
They are doing so relatively unscathed by Liberation day volatility, because the US Federal Reserve is effectively wrapping money markets up in cotton wool by maintaining a level of interbank reserves that is well above the lowest comfortable levels for participants.
Importantly, the amount of leverage granted by US primary dealers to financial market participants, using government bonds as collateral, is a useful short-term leading indicator of how well momentum strategies perform globally.
Continued growth in primary dealer leverage has historically been consistent with momentum outperforming for a little while longer.
These dynamics are likely to prove difficult to sustain on a 12-month view. After all, bonds are rallying because hedge funds are leveraging up to buy them, and because investors believe that inflation will slow enough for the Fed to cut rates. However, if inflation re-accelerates and the Fed does not cut rates, there are risks that bonds sell-off.
In turn, the value of collateral being used to support leverage will decline,
and de-leveraging becomes a real risk. Indeed, if money markets are not allowed to experience much stress, it should not surprise us that volatility in financial markets does not cause much disinflation in the real economy.
Interestingly, we find that our uncertainty indicator has historically been a more reliable (inverse) leading indicator of momentum strategy performance than primary dealer leverage.
This experience suggests that we should remain highly aware of the risks
surrounding the strategy to be truly forward-looking – and avoid being caught up in today’s dynamics. Ironically, the risk of following primary dealer leverage is that timing momentum in this way is still following momentum!
A more sophisticated approach to investing is to take note of the dynamics at work, while also recognising what could go wrong along the way – and how sensitive the market may be to these developments.
Matthew Haupt is a lead portfolio manager at Wilson Asset Management.
