The Momentum Factor’s Loss of Momentum

November 7, 2019

Source: Bloomberg Source: Bloomberg

In the last few years, environmental, social and governance (ESG) investing has become more and more mainstream, as the impact of climate change is now being considered in investment decisions. Recent wildfires in California and their impact on PG&E exemplify how climate change and the environment can affect business and investments.

Looking forward, it is likely the environmental cost of doing business will increase, just as cyberattacks have increased the technological cost of doing business.

Meanwhile, the state of geopolitics has worsened significantly, as the “every country for itself” mentality becomes increasingly widespread around the world. China, India, Russia, Turkey and Japan all have strong and assertive leaders, while Europe and Japan are mired in economic stagnation.

Domestically, high inequality and fear of technological unemployment have driven support for populist presidential candidates and ideas such as modern monetary theory.

Each of these factors paints a grim picture in its own right. However, the equity market is trading at an all-time high. How do we explain this, given the bleak macro background? What does it mean for the market going forward?

One driver is bearish positioning. While investors are cautious about a global slowdown and the U.S.-China trade conflict, a stabilization of economic data, coupled with the phase-one deal between the U.S. and China, has forced buyers back to the market.

Despite this, I am seeing a new behavior among investors: reducing risk through sector/quality/factor rotation, instead of the traditional way of outright sale.

The chart of the week shows the performance of the S&P 500 Index versus the market neutral momentum factor. The momentum index hedges out the equity market beta, as it’s only exposed to the momentum factor. As seen in the chart, when the market became volatile in May and August, instead of selling equities, investors quickly rotated into safer, lower-volatility names and the momentum factor outperformed sharply. Some of these high-momentum stocks for 2019 included high-quality, mega cap and non-cyclical names such as Microsoft Corporation, Visa Inc., The Walt Disney Company and Starbucks Corporation.

Factor investing has become popular in recent years by exposing portfolios to different beta factors. In general, this reduces the volatility of the portfolio. However, each factor can have significant volatility as well. Momentum stocks were up 12% in August and down 13% in September — experiencing more volatility than the S&P 500 Index.

This year, the factor that has gathered the largest ETF inflows is low-volatility factor ETFs. These types of holdings, which include PepsiCo Inc., McDonald’s Corporation, The Hershey Company and Johnson & Johnson, are also high-quality, large cap and non-cyclical names. This also shows that investors are reducing risk by rotation instead of selling equities. The high yield market has had a good year, but CCC bonds have had negative returns in 2019, similar to the leveraged loan market.


Key Takeaway

I may use the current high index levels to trim some investments, such as previous high flyers with very high growth rates, but negative earnings. The WeWork saga has brought fresh scrutiny to these types of investments. During this earnings season, these stocks have been severely punished for minor misses. On the other hand, the market has been tolerant of cyclical names/sectors, as valuations are much more attractive and expectations are low.  As a result, I wouldn’t mind buying some of these cyclicals to hedge a possible economic reacceleration.

Tags: ESG | factor investing | ETF | S&P 500

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High-Yield bonds are subject to greater fluctuations in value and risk of loss of income and principal. Investing in higher yielding, lower rated corporate bonds have a greater risk of price fluctuations and loss of principal and income than U.S. Treasury bonds and bills. Government securities offer a higher degree of safety and are guaranteed as to the timely payment of principal and interest if held to maturity.

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