Do momentum crashes announce themselves?

Many fundamental investors really don’t like the momentum effect. And to be honest, it does feel a bit like an insult to one’s intelligence that after all the hard work of fundamental analysis, one can just go out and buy the stocks that have gone up in the past and buy them it will be fine.

But one criticism of momentum investing is that it is extremely prone to momentum crashes, that is sudden massive downturns that are much worse than what the market experiences at the time. In November 2020, we experienced such a momentum crash after the news of a successful vaccine trial broke, and in spring 2009 when the Fed stopped mark-to-market reporting of liabilities on the balance sheets of banks we had a similar-sized momentum crash. In each of these cases, momentum investors lost several years of outperformance vs. the market in a month or two which is why momentum investing is sometimes compared to ‘picking up pennies in front of a steam roller’.

But what if the steam roller announces its arrival with a loud siren and there was a simple way to get out of its way when it comes too close? That is what a new paper from the University of Münster in Germany suggests. The researchers did something quite simple. They looked at the typical momentum factor (WML for ‘winners minus losers’) which is constructed by buying the stocks with the highest returns from 12 months to one month ago and selling stocks with the lowest returns over the same time period. Then they split this time period into two different periods that vary for each stock. They simply looked at the returns from twelve months ago to the peak share price over the last twelve months (HTP) and the return from the peak share price to the share price a month ago (PTH). And then they sorted stocks based on these two measures and formed the usual momentum portfolios based on them.

The result was stunning. The portfolios formed on the HTP momentum factor not only had a better performance than the traditional momentum factor but showed much fewer momentum crashes. In fact, during the 2009 momentum crash, the HTP portfolios had no drawdowns at all. Most of the stocks that crash seem to be captured by the PTH factor, indicating that before they crash many momentum stocks already stop their advances and start to decline from recent peaks. And by eliminating these stocks from the momentum portfolio investors can drastically reduce the probability and severity of momentum crashes. We need to better understand the causes for this effect but it seems to me that this could be a worthwhile avenue for research since markets often seem to ‘smell a rat’ when they see one.

Avoiding momentum crashes with a simple twist to the momentum factor

Source: Büsing et al. (2021). Note: MKT is the excess return of the US stock market over 3M T-Bills, WML is the return of the traditional momentum factor, HTP is the return of the momentum factor based on historic returns to peak share price, PTH is the return of the momentum factor based on historic returns from peak share price to last month’s share price.