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Value investing vs. momentum investing

Value investing is known for moats and margins of safety, but momentum investing is proven to do a better job at controlling the downside. It also happens to beat the pants off value on the upside.

In my newsletter I use very simple models to demonstrate how objective measures of momentum and value can produce far better results than complex processes involving continuous human judgement, which rarely beat their respective benchmarks. In every market from Japanese stocks to wheat futures, both the value and momentum models have delivered better risk-adjusted results than buy-and-hold. The value model achieves this by scaling you out of a market as it gets expensive, as measured by CAPE, also known as Shiller PE, for stock markets. For commodities, our value model simply compares prices to their inflation-adjusted history. The momentum model does nothing more than go long when a market makes a monthly close above its 12-month simple moving average, and go to Treasury notes when it closes below that average.

It’s easy to understand how owning less of an expensive market and more of a cheap market can keep you out of trouble and enhance returns. The trouble with this approach, and value investing in general, is that a reasonably priced market can become a cheap market, in which case you have to grin and bear it. Conversely, an expensive market can get more expensive, in which case you have to sit it out and watch fool after greater fool make gains. In any case, you are making a judgement about the price, deeming it too low, too high, or just right. Unless you deem it just right, you are saying that the market is making the wrong call, and hoping that the consensus comes around to your point of view. This can lead to frustration, as a market can stay expensive or cheap for ages. Look at Japan – our value model deemed it expensive in 1981, and stayed 80% out of the Nikkei until late 2008! In the long-run, this has been the right call, but the market went up 700% between 1981 and 1989. For someone trading many markets at once, it may have been easy to stay out, especially as the rest of the world offered great values in the 80s, but for someone living there, it would have been very difficult to stick with the model.

Japanese stocks       Value model       Momentum model

30 years later, the Nikkei has yet to break its old highs, and the buy-and-hold investor has endured four major bear markets. That’s what a Shiller PE of 70 will do to future returns – overpaying is eating the seed corn. Yes, Japan has been in a low-growth mode since their boom, but corporations have been growing their sales and earnings. It is just that earnings have had to increase by a factor of three before the prices reached in the 80s could be considered reasonable.

In contrast, a momentum investor would have ridden the boom until just after the top, sat out the initial crash, and hopped back on whenever stocks staged a substantial rally. The net result would have been a far higher growth rate without the need to endure a major drawdown. As you can see in the charts in my letter, over the last four decades, this simple system has generated returns in excess of buy-and-hold (as measured in USD) for every market I have examined, and has only been beaten by the value system in Australia. It has also worked exceedingly well in commodities, even after the costs of rolling futures contracts.

This is despite using zero information about valuation or the strength of national economies. Here we can be completely agnostic about whether a price is fair or rich, and there is no need to debate the appropriate level of CAPE in different interest rate regimes. We need no opinions whatsoever. We can just ride the rallies and step aside when prices begin to decline. Make no mistake, this too can be frustrating, as markets often whipsaw around moving averages, resulting in strings of small losses. However, this is largely mitigated by the fact that we only use monthly closing data, so that there are fewer, more meaningful signals.

The simplicity of momentum investing brings peace of mind, as there is no need to process the firehose of financial news and continually re-evaluate your views. Nor must you implicitly argue with the market – you just accept its direction and react accordingly. If you believe in the efficient market hypothesis, and I do to a limited extent, all that matters is contained in the price anyway. That markets trend in a non-random fashion has been proved time and again, but few investors realize just how exploitable these feedback loops can be, provided that perfection isn’t required and that a system is designed to capture the big long-term moves, not fight over pennies in the high-frequency game.

In conclusion, if you need the comfort of a widely-accepted approach to the markets, or if the theory of intrinsic value gives you confidence, by all means use a value system. But make it a system, make it simple, and stick with it through thick and thin. I am entirely comfortable with the value approach tracked here, and I use it to advise clients on accounts that can’t be watched on a monthly basis, such as 401(k)s. That said, I’m an empiricist, so I must acknowledge that momentum investing consistently produces better absolute and risk-adjusted results. I like to think that I have some understanding of why it works (prices must trend for the economy to function – for more read my essay on feedback loops in the August letter), but ultimately all theories are just narratives. It’s the results that matter.



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