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One would expect that any anomaly of the financial
markets which causes returns higher than the average will very quickly be
exploited by the financial industry. However, that does not seem to be the
case. Some anomalies documented for ten years of research have not been
always exploited with excess.
It is the case for example of the momentum
phenomenon of the stock exchange prices which is pretty well known since a
dozen of high level university research (published in particular in the
prestigious Journal of Finance) have confirmed its existence in a
dozen of countries, including Canada and the United States. In 1993, the
professors Jegadeesh and Titman showed that the winning securities during
the last 3 to 12 months are highly likely to be the winning securities
during the next 3 to 12 months. In 1999, professor Rouwenhorst confirmed in
12 European countries the phenomenon of the momentum effect previously
observed in the United States.
I like to describe the phenomenon of momentum in
terms of winner persistence, at least in the short run. In
concrete terms, it means that the securities which have enjoyed a strong growth
during the last 6 to 12 months tend to do better than the
average during the next 6 to 12 months. Even the mutual funds and
the exchange traded funds (ETF) are characterized by a momentum
effect. For example, the ETF which performed very well during the
last year would tend to beat the indexes during the next 12 months.
On the contrary, the securities, the mutual funds and the ETF which knew a
disappointing performance during the last 12 months have strong
propensities to repeat this bad performance during the next 12 months.
If we observe a short term momentum effect in stock
exchange prices (on a period from 1 to 2 years), there is on the other hand
a long-term reversal effect (on a period from 3 to 5 years), since the
securities which carried out significant profits during the last 3 to 5
years tend to produce lower returns than the average during the next 3 to 5
years. Some research have demonstrated the same thing for the ETF and the
mutual funds. There is thus a danger to choose its stock mutual funds in
betting on those which have made very well for five years. To proceed with
caution, it would be recommended to bet on stock mutual funds which have
given excellent returns during the last 12 months (and to only hold them one
year), but which have shown poor results in their group on a longer horizon
(at least three years).
The raisons of the momentum effect
How long will the vein last? Will the higher
returns of the momentum strategies of the stock exchange prices disappear as
soon as a significant number of investors would apply the receipt? Here are
the great questions which one wonders in front of such an anomaly like the momentum
effect. To answer it, it is initially necessary to try to understand what
explains this momentum effect and to see what its causes are.
There were sufficient research done on the subject
to draw aside certain causes. For example, it is known that the securities
which enjoy a momentum effect are not riskier or more volatile than the
others. It is also known that it is not the size of the companies or their
book value compared to the stock price (ratio price/book value) which
explains the phenomenon. All things considered, the momentum effect is
relatively independent of the risk, the beta ratio, the size of the
companies (in terms of stock exchange capitalization) and of the multiples
of valorization like the price/earnings or price/book value ratios. The
assumption of the positive feedback loop(positive feedback trading),
according to which a security price rises because it attracts the investors
who want to benefit from the upward trend (technical analysts, investors of
momentum style), was also rejected by the few researchers who made
observations on the question.
The only explanation which gains ground is the one
proposed by professors Louis Chan, Narasimhan Jegadeesh and Josef
Lakonishok, in an article published in 1996 in the Journal of Finance
and entitled "Momentum Strategies". It is even more solid as it has just
been confirmed in 2002 by professors Van Dijk and Huibers for 15 European
countries.
According to the theory advanced by all these
researchers, the financial markets are not completely efficient when
integrating new public information in the stock prices. Thus, it takes
often more than one year before the recovery of a company, the improvement
of its profitability and the resumption of its profit growth are finally
reflected in its stock price.
Let's take the example of a company which has lost,
for five years, some market shares to the profit of its competitors, or
which has seen its profit margins and its profits to contract heavily.
Suddenly, for two quarters, the measures taken by the direction to cure the
situation have started giving good results. The profits are starting rising
again and the profit margins too. Although the company seems to have made a
success of its recovery, more than two quarters will be necessary to confirm
in the investor's mind that the company has indeed corrected the situation.
In fact, the market only reacts very gradually to the good news, so that it
can take up to eight quarters (or two years) before the company stock is
adjusted with the new deal.
This very progressive reaction of the market is
moreover confirmed by the behavior of the financial analysts themselves.
Indeed, the researchers noted, on the North-American as well as European
markets, that the companies which had recorded profits higher than the
analysts' expectations at the time of one quarter tend to record profits
which once again will exceed their forecasts for the two following quarters.
In other words, the analysts underestimate the acceleration of the profit
growth of the companies which make a recovery. They only revise their
profit forecasts too gradually and too modestly.
The same phenomenon seems to characterize the
opposite situation, where a security which gave bad returns during one year
tends to repeat its against-performance in the following year. A company
which does not realize, during a given quarter, the sales and the profits
which were expected will be penalized only very gradually by the market. It
would be astonishing that the analysts who follow this company cut
drastically their target prices or emit a negative recommendation because of
only one quarter. Especially when these analysts are employees of a broker
firm which acts as banks of investment and as consultant for the company.
However, the companies which disappoint the financial analysts over one
quarter strongly tend to disappoint them on two or three following quarters.
Even if the experts downgrade their profit forecasts, it is as if they did
not cut them enough. During this time, the security only corrects very
gently or not quickly enough. Thus the phenomenon of loser security
persistence appears, on a horizon of approximately one to two years.
The structural forces which stand behind the
momentum phenomenon of the stock exchange prices are undoubtedly significant
enough to make so that the momentum investment strategies will last still a
long time. It would be astonishing that the financial analysts change their
way of working and the way they analyze companies, or the way they issue their
recommendations, even while becoming conscious of the phenomenon of
the winner persistence or of the loser persistence. One can also understand
their caution not to be too quickly enthusiastic about the companies which
seem to have made a successful recovery, just like one cannot too severely
reproach them their indulgence or their wait-and-see policy vis-à-vis those
which experience one or two bad quarters.
I think that the strategies of investment in the
strong momentum securities have a good chance of lasting, because they go
against the common sense and the feelings of the average investor. I
particularly recommend the strategy I propose on the LesAffaires.com web
site or those which other investors as James O' Shaughnessy develop for
the mutual fund industry. Indeed, they generally suppose to invest in
securities which enjoyed a return of more than 75 % during the last year,
which does not go without some reserves on behalf of the investors. They are
a lot to think that such securities are highly speculative and dangerous, or
that it is almost certain that all the correction they had to do is already
done. However, in both cases, university research showed that it is not at
all the case.
Chan, L.K.C., Jegadeesh, N., et J. Lakonishok,
Momentum Strategies, Journal of Finance, December 1996.
Van Dijk, R. et F. Huibers, European price momentum
and analyst behavior, Financial Analysts Journal, March-April 2002.
André Gosselin
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