Must-know: Momentum trading the Fed taper and your portfolio

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Risk factor #4: Momentum—Tactics versus strategy

The below graph reflects the performance of a momentum portfolio—the red line—relative to broad market indices. This momentum portfolio is long and short equal dollar amounts of stocks, so we wouldn’t expect this index to change much. In other words, the below graph reflects the returns of $1.00 invested in each of the broad market indices, which go up a lot over time. The red line—momentum—reflects the returns associated with both buying $1.00 of positive momentum stocks from these indices and simultaneously selling $1.00 of negative momentum stocks associated with these indices. So this red line (the momentum index) shouldn’t go up or down much at all—unless momentum itself is making a direct contribution to superior investment returns. This article considers the role momentum has in investing versus simply day trading, and the implications for equity investors.

Momentum Versus Major Indices

For an overview on these risk factors, please see Key strategy: 4 key risk factors as the Fed tapers.

Momentum trading: Seductive returns and free lunches

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As we discussed in the first article in this series, the one-factor CAPM model explains roughly 70% of your portfolio’s returns. The three-factor Fama-French Model that adds market size and value/growth considerations explains 90% of your portfolio’s return. Adding in momentum as a fourth factor to explain even more of your portfolio’s return really doesn’t give us any more explanatory juice.

As analysts pointed out in a fairly extensive study at the University of Iowa, “The performance of the three-factor model is qualitatively similar to that of the four-factor model both on statistical and economic grounds. Hence, attaching a greater weight to the results from the four factor model relative to the three-factor model in empirical applications may not be justified” (Gene Savin, University of Iowa, Testing the Momentum Anomaly).

Free lunches and earnings momentum for online trading companies

However, online day trading companies are eager to provide day traders with countless graphs and commentary suggesting you can beat the market and earn exceptional returns trading. While there seems to be some exceptions to the rule, on average, the rule holds. The financial success or failure of momentum traders, taken on the whole, is likely to reflect in the above graph—they make money when momentum exposure is generating excess returns, though they give it back when momentum exposure is negative.

Tactics versus strategy

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As the above graph suggests, momentum trading can be a great tactical tool to chase short-term gains. However, as a strategic long-term investment factor, momentum exposure can affect investment returns, though it doesn’t systematically explain the portfolio returns any more than the consideration of the three factors noted in the first part of this series—market risk, value versus growth, and small versus large cap.

To see how momentum trading stock Green Mountain Keurig performed, please see the next article in this series.

Equity outlook: Constructive macro view

Despite problems in Ukraine and China, and despite the modest consumption data in the USA, U.S. labor markets appear to be well into recovery—with the exception of the long-term unemployed. From this perspective, it would appear that the U.S. is probably the most attractive major investment market at the moment. While the fixed investment environment of the U.S. is still quite poor, corporate profits and household net worth have hit record levels. Hopefully, all of this wealth and liquidity can find their way into a new wave of profitable investment opportunities and significantly augment the improvement in the current economic recovery. For investors who see a virtuous cycle of employment, consumption and investment in the works, the continued outperformance of growth stocks over value stocks could remain the prevailing trend, favoring the iShares Russell 1000 Growth Index (IWF) and growth-oriented companies such as Google (GOOG) or Apple (AAPL).

Equity outlook: Cautious macro view

Given the China- and Russia-related uncertainties, investors may wish to consider limiting excessive exposure to broad equity markets, as reflected in the iShares Russell 2000 Index (IWM), the State Street Global Advisors S&P 500 SPDR (SPY), the Dow Jones SPDRs (DIA), and the iShares S&P 500 (IVV). Accordingly, investors may wish to consider shifting equity exposure to more defensive consumer staples–related shares, as reflected in the iShares Russell 1000 Value Index (IWD), such as Walmart (WMT).

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