In their paper “Momentum Crashes”, Kent Daniel and Tobias J. Moskowitz set out to build a better momentum strategy. After reviewing the research on momentum strategies for equities of the years they dive in and create a strategy that aims to avoid the periods when momentum strategies dramatically under-perform the markets:
We show that the low ex-ante expected returns in panic states are consistent with a conditionally high premium attached to the option-like payoffs of past losers. An implementable dynamic momentum strategy based on forecasts of momentum’s mean and variance approximately doubles the alpha and Sharpe Ratio of a static momentum strategy, and is not explained by other factors.
Their primary finding is that stocks that have done very poorly in a market downturn, often outperform when the markets turn around. They go on to explain this in a very mathematical fashion and suggest that:
in bear market states, and in particular when market volatility is high, the down-market betas of the past-losers are low, but the up-market betas are very large. This optionality does not appear to generally be reflected in the prices of the past losers. Consequently, the expected returns of the past losers are very high, and the momentum effect is reversed during these times.
To put in plainly, without the math, stocks that have been punished during a downturn often go on to out perform the market when the recovery starts. The junk rally in 2009 is a great example, the stocks most beat up in 2008 were some of the highest gainers in 2009.
In the end it is a pretty common sense finding, since much of what causes stocks to crater has more to do with psychological panic than real market fundamentals. It stands to reason that irrationally punished stocks will outperform when the market regains a modicum of rationality. We see this phenomenon all the time, particularly when high ranking individuals leave companies or their is a extra salacious headline out about a firm. These events make big news and move stock prices, but often don’t have the slightest effect on the true underlying value of a company.
What does it mean for investors? Not a whole lot unless you are looking to build a complex momentum model, but it does serve as a nice reminder that even in the midst of market chaos there are good opportunities to be had.
Full paper here