- Idiosyncratic momentum is a sense check to macro-led moves
- Strip out beta to spot shares with rebound potential
Many investors will be wondering whether St. Nick judges them naughty or nice this holiday as they await the famed Santa rally for equity indices. Much depends on whether central banks leave out sherry and mince pies in the form of signs they might relax the crash diet of rapidly rising interest rates. Should that not be the case (all will become clear shortly after this issue of the IC goes to press), there may be a lump of coal, or perhaps something more in keeping with net zero carbon targets.
The Santa rally phenomenon, first written about in The Stock Trader’s Almanac by Yale Hirsch in 1972, is perhaps the most famous example of seasonal momentum. But shifting monetary policy regimes coupled with a darkening economic outlook is spicing up all kinds of quant and factor-equity strategies at the moment.
Societe Generale’s (SG) cross asset research team note the power of trend-following in 2022: momentum strategies that go long or short US companies based on their previous 12-month share price direction delivered their best performance since 1989. Most of that return came from short positions thanks to the drastic falls in stocks from expensive valuations.
Retail investors won’t typically be shorting stocks. But for any momentum strategy, one big risk is that of the reversal – that a share price suddenly starts moving in the opposite direction. Not all these reversals will be sustainable: rebounds that occur because the likes of hedge funds are covering or taking profits on short positions shouldn’t be mistaken for sustainable recoveries. In a highly volatile market, these risks become more common.
Beta risk rising for individual shares
Reviewing the factors that have influenced returns this year, SG calculates the weight of market direction, or beta, is exerting twice the influence on individual stock prices than it was 10, 20 or 30 years ago. Their quant team cautions that using share price momentum factors in the stock selection process leads to portfolios being exposed mostly to underlying macro stories rather than company specifics. And when the big picture narrative changes, then there are “gut wrenching” losses for investors on the wrong side of a trade.
Traditional price momentum, SG concludes, is too dangerous a strategy to pursue. The French investment bank prefers to isolate stock-specific performance, which sounds very much like alpha – the portion of returns that is down to skillful stockpicking. That’s different, however, from SG’s methodology for isolating "idiosyncratic" momentum, which is essentially pure factor investing.
Primarily, SG quants are concerned with the risk that strategies shorting negative momentum stocks find themselves squeezed out by powerful recoveries. Screening for companies with lower beta and other factor risks provides a good clue both to the types of shares that are more resilient to strong selling, and those that can recover based on their own merits and not the whipsawing of the market.
Conventional momentum is defined by SG as 12-month total returns (it is interesting that income is included) lagged by one month. Idiosyncratic monthly returns are calculated as part of an equation to separate beta from stock returns; the cumulative value of these stock-specific returns over the past year (excluding the last month) is what constitutes the idiosyncratic momentum (IMOM).
There is an additional level of analysis that also removes that which can be attributed to the other two factors of the famous model by Eugene Fama and Kenneth French: the portion of returns attributable to a share's size (by market cap), and that attributable to its value (past cheapness). The output of this model is referred to thereafter as the Fama & French Idiosyncratic Momentum (FFIMOM). From the private investor's perspective, sense checking momentum picks to see how their size and past cheapness has affected returns should not prove as complex as that acronym looks.
Finally, both IMOM and FFIMOM factors can be divided by their annualised volatility, which gives a risk-adjusted proxy of the significance of residual returns. Ranking stocks on these metrics, the SG team found that buying the top deciles and shorting the bottom deciles of IMOM and FFIMOM stocks has historically produced vastly better risk-adjusted performance than simply going long/short based on the traditional momentum factor. Volatility adjusted versions also beat the standard momentum output and did (as is intuitive) even better on a risk-adjusted basis.
Our takeaway going into 2023 should be that shares that have risen strongly on the back of their idiosyncratic momentum are probably companies that deserve some individual analysis to see if the reasons behind the rise will continue. If these are businesses that have the characteristics of reliable long-term compounders, they will be worth owning – on the proviso they aren’t now too expensive.
More interesting, however, could be those shares that have sold off despite having little idiosyncratic momentum. If a company has been dragged down purely because of the market or other factors, there may be a good business that has been unduly punished and is ripe for a rebound.
Further research by SG suggests that the more companies have been sold from their previous peak (especially in the absence of idiosyncratic negative momentum), the more likely subsequent periods of positive returns are. While that’s bad news for short sellers who haven’t done their homework, watching out for such companies could provide cheer into the New Year for savvy investors.
