Monsters of Momentum take fright

The 18 stocks selected by the Monsters of Momentum screen this time last year have delivered a starkly negative total return of 13.1 per cent compared with a positive 9.6 per cent from the FTSE All-Share, which is the index from which shares are chosen.

2016 PERFORMANCE TABLE

Source: Thomson Datastream

True, the six-year cumulative gain continues to look very impressive at 130 per cent - or 107 per cent if I include a 1.5 per cent annual charge for dealing costs - compared with 48.5 per cent from the market. Nevertheless, the lousy past 12 months is a reminder of this strategy's risks. Indeed, all screening strategies should be expected to go through bouts of underperformance with the goal of market-beating returns only being a longer-term objective. This is a key reason most investors only like to use screening as a way to generate ideas for further research.

Monster mayhem

Source: Thomson Datastream

Reversion to the mean is a powerful phenomenon, and just as this screen had enjoyed several strong years prior to this one, there is no reason to think it can't manage a spate of underperformance, too. However, aside from the unpredictability of returns over the short term, it is worth considering if the poor performance of the past 12 months can tell us something about the current state of the market.

While last year's screen results only represent a narrow band of stocks that happened to be flavour of the month at the time the screen was conducted, one possible conclusion that could be drawn from real dogs is that froth is coming out of the market. Brexit aside, some of the biggest disappointments came from 'high-growth' momentum plays that failed to deliver on promises. This caused the high ratings on stocks such as Sepura (SEPU) and NCC (NCC) to be punctured, exacerbating the impact of broker downgrades based on trading disappointments. Sepura has actually received a takeover approach at the time of going to press, but this is only set to undo a small portion of the damage shown in the above table.

This observation could have wider relevance based on the forward PE currently attached to the FTSE All-Share. On a 10-year view the current PE looks expensive and is in the top fifth of the range over that time. However, if we look at what has happened during 2016, the index's earning multiple does not look so healthy. Indeed the FTSE All-Share forward price-to-earnings (PE) ratio of 14.6 has dropped by a tenth from its 2016 peak to of 16.2, which was set in April, and is down 11 per cent from the 10-year high of 16.4 times set in April 2015. Indeed, the index's forward PE is currently in the bottom tenth of its one-year range.

High valuations have in part been justified over recent years by low bond yields, which encourage investors to view long-term earnings streams as more attractive. More recently, though, yields have been rising and there are some expectations that this could actually prove a sustainable trend. This may also be the reason for outperformance of value stocks compared with growth stocks over the past month, which represents a very tentative reversal of a 10-year trend of outperformance by growth.

The Monsters screen looks for FTSE All-Share stocks passing four momentum tests. The criteria are:

As only two stocks passed all the tests, the list below includes 12 other stocks that passed the price momentum and trend tests but failed one of the other two. This screen has produced insufficient results for several years and the softening of the criteria I am using is the same as I resorted to last year. I've provided write-ups of the two stocks that passed all the screen's tests (NMC and Tesco) along with the stock showing the best momentum (Ferrexpo).

2016 MONSTERS

Source: S&P Capital IQ