Credit: Shutterstock photoMichael Allen submits:
Felix Salmon kicked up a storm of consternation when he reprinted the Bank of England 's chart comparing Momentum vs Value strategy returns showing that the momentum speculators $1 stake would have grown to over $50k while the value investor 's $1 stake would have shrunk to 11 cents .
First of all , as Salmon himself requested , I have compared the returns to the buy & hold strategy . I have also converted the returns into current dollars to account for inflation . Buy & Hold underperformed dramatically during the entire period , but look what happens when we trace the relative performance in Chart 2 . All of the out -performance occurred prior to 1950 . Since then , the momentum strategy has mostly under -performed buy & hold , and would have done so by a very significant margin if not for some significant catching up between 2000 -2002 and between 2007 -2009 .
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Even the performance during these recent two periods is subject to some debate . The Shiller data base includes only monthly closing prices . To follow the momentum model as it is stipulated , you have to know the closing price at the end of the month before you can decide whether to go long or short the market for the next period , but the model assumes that you made this purchase or sale at the close of the previous month . That is impossible to execute in real life . It is possible for a very diligent investor to have bought the SPY ETF in the after -market with very little slippage , or for an institution to have bought the futures , but it would have been very important to do so . If we use Tradestation 's back-testing tools , we are required to close any existing positions and open any new positions at market on the next day 's open . With this constraint , the momentum strategy leads to a small net loss of 0.4 % during the past 13 years , compared to a 38 % gain from the buy and hold strategy .
These comparisons do not include dividends , but it is impossible for dividends to improve the case for the momentum strategy because the buy & hold strategy receives all dividends , while the momentum strategy probably does not and probably has to pay out some of the dividends when it is short .
As for the value strategy , it is a straw dog . No value investor would ever short the market just because it is a point or two over -valued . At any rate , a dividend discount model requires a long -term forecast , and it is highly problematic to back -test with accuracy what any given analyst would have used as a long -term forecast in each and every month of the test . What we can do is use the historical P /E ratio and come up with a slightly more realistic formulation of what an actual v alue investor might really do, which is to own more of the market when it is extremely cheap , and own less when it is extremely expensive . I cannot emphasize enough that we must use of the word "extremely. " Valuation is a crude way to set a price target in any environment . A well thought out assessment leaves you with a range of plausible prices . The idea that valuation can ever give you a precise target is drivel , so a reasonable value investor would only divest when the range of plausible price targets leaves little room for upside .
We still have to define fair value . Between 1880 and 2010 , the average P /E , based on Shiller 's definition of earnings , has been 14x . Note that this definition is distinctly different from Wall Street definitions as it includes expenses that normal people would usually conclude are expenses , and also because it is historical and not a forecast . But in 1880 , no one could have known that 14 was going to be the magic number . In 1890 , for example , the average P /E for the previous 10 years was 11x . It is easy for us to say now that stocks were a bargain back then , but there was no way to be certain of this in real time . As an experiment , I defined the 10 -year running average as "fair " value and 2 standard deviations below this as cheap and 2 standard deviations above as expensive . This is not necessarily a true or scientific measure of "fair " value , but I could argue that it is probably very close to what the consensus estimate of fair value would likely have been at any given time . It is not perfect, but I think it will tell us something useful.
This simple value strategy massively out -performs the buy & hold strategy , but there are periods of massive , stunning under -performance that would probably not be tolerable to most investors . Two episodes of supposed undervaluation were the most notable . From 5 /1973 to 3 /1975 the market remained more than 2 standard deviations below the previous 10 -year average and during this period , stocks declined and the value strategy underperformed by 69 %. From 1 /1916 to 3 /1918 , stocks remained more than 2 standard deviations below the previous 10 -year average , but stocks nonetheless declined , and the value strategy under-performed by 62 %. All of the other significant bouts of underperformance were attributable to under -valuation and the use of leverage . All extended periods of over -valuation , without exception , helped the value strategy to outperform buy & hold .
Unfortunately , as well as this model has worked in the past , it appears to be broken by the unprecedented 90 % drop in earnings in 2009 . Currently , the market trades at 17.3x Shiller 's definition of EPS , while the 10 -yr historical average has risen to 30.8x . The standard deviation , however , has risen to 22.2 , so that in order for stocks to be cheap on this model , the PE has to be negative , and for stocks to be expensive , the PE has to be 75.5x ! A relatively simple fix that does not alter our results or conclusions is to ignore the quarters in which S &P earnings were more than 50 % below the peak . If we do that , the long -term running average P /E drops to 24x . The standard deviation is still wide , but does not require a negative P /E to become under -valued .
If we are value investors , we still have a couple of serious problems : The model does not recommend leverage at this point, but it does indicate that stocks are pretty cheap. The problem is that, at no other time in history would stocks trading at 17x EPS have b een considered anything but a complete rip-off. Do we dare follow the model in this situation? For another , there is no time in history when an "under -valued " rating would have given the value investor an edge . If we look at past instances when stocks were cheap relative to their recent 10 -year average, but expensive relative to longer-term averages , we can detect a very persistent and disturbing pattern . Typically , stocks keep going down , often until they become cheap even by longer-term measures. This is especially true when the 10-Yr average P /E is in a downtrend , as it is now .
This is not a definitive study and isn 't meant to answer every question that could be raised in relation to the value vs momentum issue , but hopefully , I 've unraveled some of the mysteries .
Note: For periods in which the value strategy was less than 100% invested, I used the 10-year treasury bond yield to compute returns of the uninvested portion. I did not have data on changes in principal for such bond investments, but the periods effected were typically so short that they are unlikely to have had a significant impact. If anything, this probably distorts against the strategy rather than in favor of it. Anyway, for this distortion, I apologize.
Disclosure: No positions
See also Small Caps: Cheap, Small and Dominating the Market on seekingalpha.com
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
