Momentum Investing Does Even Better with Inversions

Momentum Investing

The lower bond yields of today have some investors and market observers nervous. It turns out that momentum investing works even better with small yield gaps and inversions.

Among the people who invest in stocks, some just buy and don’t even pay attention to their positions or their outlook. Their stocks may be tanking, the market may be tanking, the outlook may be grim, but they do their best to resist the urge to sell.

Sometimes they do end up exceeding their rather high pain thresholds and sell, but when they do, it’s usually at the wrong time, after most or all of the damage has occurred. When things do turn around, since they didn’t really have a plan to begin with and just exited out of sheer panic, they aren’t prepared for the rebound either and will often just stay on the sidelines and watch as their stocks regain their losses and even add more gains.

Some investors though do try to manage their positions and may even actively manage the makeup of their portfolio, holding stocks while they are performing well and replacing them when they aren’t. These are called active investors. As sensible as this sounds, a low percentage of investors are active investors, and many active investors are really aren’t all that active and might only jump into action during times of substantial concern.

Warren Buffet would certainly qualify as an investor whose activity is quite limited, and while many may think that he’s an inactive one, he does move in and out of things here and there, but he’s also quite willing to ride stocks while they are driven into the ground as well.

His huge position in Kraft Heinz is a great example of this. Kraft Heinz stock broke down a couple of years ago in a way that did not portend well, and the goal of investing should be to enter and stay in positions that bode well and exit ones that do not.

Kraft Heinz has lost 70% since then, and Buffett is still hanging on, although at this point the horse has left the barn, and with the size of his position, his selling now would really drive a stake into the stock. It’s still making all-time lows though and even down here it’s a real dog.

Warren Buffet can’t move in and out of positions like we do, unless we have billions of dollars that is, so he plays an entirely different game. We don’t want to play his game though because he invests with a big handicap and no sensible investor would want to emulate that.

With Investing, Results Need to Matter

The real way to do this is to select and monitor your stock positions based upon results. While many may look to fundamentals to base their decisions on, whatever that is going on that is affecting the price of a stock can be found on their charts, just like we see when we look at Kraft Heinz’s.

You don’t have to know a thing about the company, even what it makes, to see this stock break down back then, and this is especially the case once the tanking started. The hit that they took earlier in the year was only part of the story as this stock has performed terribly since all the way back in February 2017. We do need to give these stocks some room, and as investors, we can’t just sell on every pullback, but when the more meaningful ones come, we do need to go.

Basing our decisions on the performance of a stock is called momentum investing, where we look at the momentum upward or downward that a stock has and base our entries and exits upon how this all plays out.

Momentum plays are actually the only sensible way to invest, as anything else just has us guessing and has us guessing wrongly a lot. Price and the “shoulds” as we can call them, as in a stock should do this or that based upon some belief we have, don’t always correlate very well, and anytime the “shoulds” are wrong and you trade this, you end up being wrong.

The neat thing about looking at price is that it always correlates with price, and will always have you on the right side of seeing what a stock is doing and wondering why it isn’t doing what we think it should. Price takes the should right out of the equation, as it should be.

Price is always right because that’s how we keep score. If there are 1001 things that are moving price, we get to see how all these factors interact with a stock’s price right in front of our eyes, with complete accuracy, when we look at a chart or otherwise monitor price performance.

Within these movements are trends, and the idea that everything that can be known about a stock’s value is incorporated in its price involves a fundamental misunderstanding of what causes price change, which is the betting action itself, the movements in outlook by market participants.

Some will even claim that there is no discernable momentum with stocks because they move in a random fashion, even though this not an idea that corresponds with reality in the least. The movement in stock prices do not contain any elements of chance in fact, let alone be driven by it.

Rather, we see distinct trends emerge on charts of stocks, like the downward one we see with Kraft Heinz for instance. While we do see some wiggles along the way, the overall trend in this case is down, and other stocks may have an overall trend that is up.

We can also look at relative performance over a given time period, and this is an even simpler approach because it requires no charting skills at all, and all we have to do here is know that one number is bigger than another. If we look at, for instance, a stock’s 52-week performance, this can give us a lot of insight indeed as to how much love or lack of love a stock is getting.

If we examine this and see one of our positions doing very well, one doing decently, one which has mildly underperformed, and one that has gone down in value a lot, it shouldn’t be too difficult to decide what to do as long as we understand the significance of momentum.

The good performer is a keeper of course, and while keeping it won’t guarantee that it will continue to do well, it hasn’t given us a reason to get out, and the probabilities right now are in its favor due to its current level of performance.

With the one that is doing terribly, unless this stock just tanked quickly and unexpectedly, we must bear the blame for this fate and should have been out of this a while back, back when it started to show us that holding it further wasn’t such a good idea. This is not ever about being right all of the time, just being right more often than wrong, and when holding something is more wrong than right, that’s the time to go.

With the mildly underperforming one, when a stock underperforms, it’s time to go as well, because why would we really want to be in a stock with bad odds? The one that is performing decently will at least require an assessment, to see if there might be something else out there which has better prospects that we could put our money into instead.

Riding the hot stocks and getting out of the cold ones is momentum investing pure and simple. This is not about holding stocks that have greater potential for momentum, this is about actual momentum. This is not about holding high beta stocks and then taking a hit on them later, as when the heat comes, that’s when we just get out of the kitchen with this strategy, without even thinking about it.

Momentum Investing Works Well in All Conditions

We have lots of data to support this all being a good idea, and this should also be very intuitive as well. If we had to choose which stock to hold, one running well or one running badly, the fact that the one running well outperforms the badly running one going forward simply makes sense.

Some might worry that when the overall market and conditions that may shape the market aren’t looking so great, that we might want to be more careful with momentum plays like this. However, since we are basing our decision-making process solely on the price performance of our stocks, there isn’t anything else to even think about let alone worry about.

There could be times where we may not be able to find a single stock worth holding, at least for a time if the market were crashing, but the noise of a falling market will be heard very clearly by us and to the exact degree that it matters, which is how all this may be affecting our stock.

With bond yields so low and the gap between the 10 and 2-year treasury being so thin, there are people who are worrying about this, and we actually have looked back to other times to see how stocks with good momentum have fared against lesser ones.

Oppenheimer analyst Ari Wald has compared the performance gap between high momentum stocks and low momentum ones during times where the 10-year treasury has been more than 2 percent above the 2 year, and when it has been less than 1 point above, as well as when we have an inversion.

The 10-year being 2 percentage points in yield above the 2-year might not happen for quite a while as this requires interest rates and inflation to be high, and with us on the brink of an inversion again, the gap is definitely below 1% and well below it, So, it may be good to know how high-momentum stocks do in this environment, even though it may not even make sense to think that low-momentum stocks would ever win in any scenario because we’re managing this to ensure that we stick with the right horses regardless.

Wald points out that when the 10-year is 2 points or higher than the 2, good stocks beat bad stocks by an average of 3.4 percent over the next year. When the gap is between 0 and 1, the good stocks come ahead by 12.6 percent over the next year, and when we have an inversion, this number grows to 18%.

We are left to speculate as to why this performance gap grows so much or even why it is correlated to treasury yields but it may be that investors are more focused upon the now when this gap is small or inverted, and end up noticing more what the right thing to do would be, which would be to get out of our bad positions and build more good ones.

When this happens, this puts the price of the good stocks up and puts the bad stocks down, due to this rebalancing.

Some seem to find this effect counterintuitive, as they may think that the sort of stocks that tend to be the better ones would be more prone to a reversal. The first thing to realize is that a stock’s price is purely a matter of the outlook of those that trade stocks, and also that this strategy, when used correctly at least, will keep us in the stocks that the market likes and out of the ones that they don’t, and when hard times do come, it’s just better not to be in ones that are already disliked.

This should at least serve to allay the fears that some momentum investors may have about inversions, although if we manage our positions properly there should be no reason to fear anything really. The 12-month horizon that Wald uses is instructive but would never be something that we would use, since managing with momentum is a dynamic process and not one that we would want to set a limit like this on.

Along the way there will likely be decisions to be made to further help ourselves, but if we are actually watching the story of our portfolio unfold and making decisions about it based upon the only thing that matters, how our investments are doing, we are on the right road at least.

Watching the road and reacting to it, instead of only using selective attention or not even looking is simply better in all road conditions.

Ken Stephens

Chief Editor, MarketReview.com