I started my career as a value investor but as people who know me for a long time (or who have followed these missives for a long time) I have become somewhat of a ‘lapsed value investor’.
Jun 7, 2022·edited Jun 7, 2022Liked by Joachim Klement
Great article! But I am perplexed by your conclusion: "Instead, value investing may be due for a permanent decline as markets become ever more short-term oriented."
My understanding is that:
1. There are capacity limits to every strategy.... so when the strategy gets overcrowded the money moves somewhere else (to Value maybe?)
2. Momentum/Trend following might drive Valuations up. At one point Overvaluations will be deemed unbearable any longer, prices collapses, and a people shift towards fundamental strategies (like Value, Profitability)
3. Short Term Momentum seems to work best with high turnover stocks (=Largest 500 stocks), and doesn't work so well with with Small Caps (before transaction costs!) (FF6 Alpha t-stat: 1st quintile (microcap) -1.26, 2nd quintile 0.07) (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3150525 and https://alphaarchitect.com/2022/06/short-term-momentum/). So if "value investing may be due for permanent decline" would be true, then this would be true for the S&P 500 segment, and not so much for the small cap segment?
Yes, the decline of value is mostly the case for S&P 500 stocks, not so much for Small and mid caps. The value effect for smaller stocks remains bigger, though it is declining there as well.
As for your points 1 and 2 I agree with you in theory. The fun thing about the capacity for momentum strategies is that it increases with the momentum effect. The more a stock outperforms, the larger its market cap becomes and the more "capacity" it has to absorb additional investments, which in turn create even more price momentum. The true capacity limit for momentum is the amount of money investors are willing to put into overvalued stocks.
Which brings me to your second point. The biggest challenge for momentum investors are momentum crashes. Momentum works very well for a long time and then crashes suddenly. The last momentum crash we saw in the US in November 2020 when pharma companies reported successful trials for Covid vaccines. All of a sudden all the pandemic winners like Peloton, etc. crashed and the downbeat value stocks rallied.
Empirical evidence shows that these momentum crashes can wipe out several years of momentum outperformance, but that they are so rare that in practice, momentum still creates a lot of outperformance. In a sense, momentum payoffs are a mirror image of value payoffs. Value stocks (and I speak as a former value-oriented money manager) underperform for a long time until suddenly they pop and rally significantly in a relatively short time (see energy stocks over the last six to ten months vs. energy stocks over the last decade).
And with these differences in the payoff distribution =between value and momentum come psychological challenges for investors. Most investors have a hard time sticking with value stocks long enough until they pop, but have no problem sticking with momentum stocks even if they occasionally create a big hole in their portfolios.
A Keynesian beauty contest in other words?
Great article! But I am perplexed by your conclusion: "Instead, value investing may be due for a permanent decline as markets become ever more short-term oriented."
My understanding is that:
1. There are capacity limits to every strategy.... so when the strategy gets overcrowded the money moves somewhere else (to Value maybe?)
2. Momentum/Trend following might drive Valuations up. At one point Overvaluations will be deemed unbearable any longer, prices collapses, and a people shift towards fundamental strategies (like Value, Profitability)
3. Short Term Momentum seems to work best with high turnover stocks (=Largest 500 stocks), and doesn't work so well with with Small Caps (before transaction costs!) (FF6 Alpha t-stat: 1st quintile (microcap) -1.26, 2nd quintile 0.07) (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3150525 and https://alphaarchitect.com/2022/06/short-term-momentum/). So if "value investing may be due for permanent decline" would be true, then this would be true for the S&P 500 segment, and not so much for the small cap segment?
Yes, the decline of value is mostly the case for S&P 500 stocks, not so much for Small and mid caps. The value effect for smaller stocks remains bigger, though it is declining there as well.
As for your points 1 and 2 I agree with you in theory. The fun thing about the capacity for momentum strategies is that it increases with the momentum effect. The more a stock outperforms, the larger its market cap becomes and the more "capacity" it has to absorb additional investments, which in turn create even more price momentum. The true capacity limit for momentum is the amount of money investors are willing to put into overvalued stocks.
Which brings me to your second point. The biggest challenge for momentum investors are momentum crashes. Momentum works very well for a long time and then crashes suddenly. The last momentum crash we saw in the US in November 2020 when pharma companies reported successful trials for Covid vaccines. All of a sudden all the pandemic winners like Peloton, etc. crashed and the downbeat value stocks rallied.
Empirical evidence shows that these momentum crashes can wipe out several years of momentum outperformance, but that they are so rare that in practice, momentum still creates a lot of outperformance. In a sense, momentum payoffs are a mirror image of value payoffs. Value stocks (and I speak as a former value-oriented money manager) underperform for a long time until suddenly they pop and rally significantly in a relatively short time (see energy stocks over the last six to ten months vs. energy stocks over the last decade).
And with these differences in the payoff distribution =between value and momentum come psychological challenges for investors. Most investors have a hard time sticking with value stocks long enough until they pop, but have no problem sticking with momentum stocks even if they occasionally create a big hole in their portfolios.
Thanks for your answer
Are you aware of any AIF or mutual fund that follows a short term momentum signal strategy ?
(I would assume that getting
In early becomes more important when more people crowed in as absurd / unbearable valuations might be reached faster .)
No, I don’t know if any. I guess some hedge funds will be experimenting with that within a larger collection of strategies, but nothing srandalon.