Sixteen Momentum Monsters

As the American journalist James Surowiecki has shown in his study of collective decision-making, The Wisdom of Crowds, “groups are remarkably intelligent, and are often smarter than the smartest people in them”. This, Surowiecki says, is thanks to the greater diversity of opinion, independence of members, decentralisation and aggregation that exists in a large, disparate group.

No matter how well informed, the same group’s smartest expert can never harness these conditions, and so will sometimes struggle to forecast with the same degree of accuracy.

To the legendary investor Jim O’Shaughnessy, each of these conditions are present in financial markets. Not only do share prices act as “an aggregator of all market opinion about the prospects for that stock”, but their relative strength is also a decent indicator of its near-term performance.

In a review of US price data across the second half of the twentieth century, O’Shaughnessy found that buying the past year’s best performers generated alpha. Investors who focused on large-cap stocks with the strongest price momentum did especially well. In short, Surowiecki’s wise crowd theory is reflected in the historic record of stock price momentum.

The caveat to all of this is unfortunately rather large. For this positive feedback loop to work, it transpires, market conditions need to be ‘ordinary’. O’Shaughnessy found that the effectiveness of momentum breaks down when an equity bubble or bust has formed. “At these market extremes, a uniformity of opinion occurs that impairs the ability of a group to offer good collective judgment,” he writes in his magnum opus, What Works on Wall Street.

The problem with bubbles and busts is that it is always hard to tell when one lies ahead. In hindsight, we can say with confidence that 2022 has been a textbook example of the latter, in part likely because markets were very recently in the former. Equity bubbles have a habit of bursting on contact with the suddenly sharpened needles of monetary policy, inflation and curtailed spending.

As we have documented in these pages, this doesn’t mean momentum investing has come unstuck of late. Our quarterly momentum screen, which goes long the best performing stocks in the FTSE 100 (and short the worst performers), has beaten the blue-chip index over the past year. Our No-Thought Portfolio, which uses a similar strategy for two of its six quarterly-rebalanced strategies, has also outperformed its benchmark thanks to bets against falling FTSE 350 stocks.

Our annual Monsters of Momentum screen, which scours the FTSE All-Share for stocks with positive momentum, has had no such luck.

Though the index has struggled badly in this period – falling 3.8 per cent on a total return basis – the 25 stocks selected by the screen in November 2021 had an abysmal showing, posting a 16 per cent loss. The crowd, quite clearly, did not see this market correction coming.

Indeed, just six of the shares were in positive territory, and a few proved unmitigated disasters. Two names in particular – JP Morgan Russian (JRS) and Raven Property (RAV) – were chewed up spectacularly by geopolitical events and sanctions which few anticipated this time last year. Their share price declines account for almost half of the screen’s underperformance, though in the case of the now-untradeable Raven Property, the mark down should arguably be 100 per cent.

2021 performance

The screen is one of the oldest that feature in these pages. Despite a disappointing 2021-22, its overall 12-year performance record has been both consistent and strong. Not only has it beaten its benchmark in three out of every four years, but its cumulative total return of 319 per cent is almost triple that of the FTSE All-Share, up 96 per cent over the same period.

While the screens in these pages are meant as a source of ideas rather than off-the-shelf portfolios, if we add a 1.5 per cent annual charge to represent notional dealing costs and inject a dose of trading reality, the total return drops to 250 per cent. Though this is still well ahead of the index, it shows the considerable erosion in returns that can accompany continual portfolio reshuffles.

The screen itself is pretty straightforward: it just wants to see a monstrous amount of momentum. This means testing for momentum in price, moving-average trends, earnings and volume. The full criteria are as follows:

■ Price momentum: a share price rise in the top 10 per cent of shares screened over the past three months, in the top 25 per cent over six months, and in the top 50 per cent over a year.

■ Trend: the 10-day moving average must be above the 30-day, which in turn must be above the 100-day.

■ Earnings growth: average forecast earnings growth for each of the next two financial years must be among the top quarter of all stocks screened.

■ Volume: average daily volumes over the past three months must be above the level from a year ago.

Broadly speaking, I think these tests strike a nice balance between sources of momentum. As detailed above, price performance is a proven factor (when markets are orderly), while improving analyst and investor optimism – as indicated by rising earnings forecasts and trading volumes – are generally a sign that a market is putting its money where its mouth is.

I recently explained why I am somewhat sceptical about technical indicators like moving averages, and all that they suggest about the nature of investing and price discovery (‘Ideas Farm: Bouncing Back’, IC 28 October 2022). But I will caveat this by saying that the use of price trends can be beneficial if followed in a formulaic and consistent way. My hunch (at least based on this year’s results) is that the trend test acts as an extra filter to the price test to whittle down the results. Whether it improves the screen’s returns is harder to say.

As with last year, not many shares qualify. In fact, just two names – former Investors’ Chronicle owner Pearson (PSON) and payment solutions provider Network International (NETW) – passed every test. We’ve therefore allowed other stocks through the screen based on the same weakened criteria we used in both 2020 and 2021. This requires stocks to pass the key price momentum test, but only two of the other three tests.

Sixteen stocks pass the screen on this basis and details can be found in the table at the end of this article.

2022 Stocks