The idea of momentum trading might seem counterintuitive: instead of digging through small, unnoticed stocks to find hidden gems, you buy into yesterday’s fads. Did a stock perform well recently? Buy it. Did a stock perform poorly? Sell it. Curiously enough, this strategy often works. Yet while momentum can produce consistent returns, it also is prone to rare, sudden crashes.
Those crashes predominantly occur at pivotal points in the economy, when a bear market suddenly ends and stocks dramatically rebound. In such environments, last year’s losers perform magnificently, while winners lag dramatically—the opposite of what a momentum trader would be betting on. Chicago Booth’s Tobias J. Moskowitz and Kent D. Daniel of Columbia Business School attribute these setbacks to the effect of the stocks’ beta, or exposure to the market: when you buy winners and sell losers, you are picking stocks that are more sensitive to overall market swings.
The researchers examine the mechanisms behind these momentum crashes, first to understand them, and then to search for a way to ameliorate the risks. They find that after recessions, momentum trading becomes asymmetric. Inexplicably, during momentum crashes, the losers are more tied to the market movement than the winners are. Because of this feature, Moskowitz and Daniel suggest that selling losers in momentum crashes is similar to shorting call options, a terrible strategy when the overall market is climbing.
Volatility is a warning sign, but it is impractical for traders to liquidate all their holdings into cash as soon as volatility appears. Instead, Moskowitz and Daniel propose a formula for “dynamic momentum trading,” which allows investors to increase their momentum trading when volatility is low and decrease it when volatility is high.
The history of modern finance is not littered with large momentum crashes—only the Great Depression and the recent housing bubble qualify. (The two worst months for a momentum strategy that buys the top 10 percent of stocks over the past year and shorts the bottom 10 percent were July and August 1932.) So the researchers extend their field, gathering data from eight different markets and asset classes, including US equities, bonds, currencies, international markets, and commodities. They find the same asymmetry between winners and losers, regardless of what is being traded.
Dynamic momentum trading capitalizes on aspects of the pattern, but it doesn’t explain the pattern’s existence. It is easy to come up with hypothetical explanations for why losers behave differently from winners, though none is conclusive. Moskowitz briefly considers that it is harder to sell short than to buy long, yet the same asymmetry is evident in futures and commodities markets, where short selling is much easier. Daniel looks at behavioral research that shows that in extreme situations, people become fearful and focus much more on losses rather than gains, but exploring that possibility would require further study.
Defenders of the efficient-markets hypothesis—which suggests in its strongest form that past price movements should not predict future results—speculate that investors can reap consistent gains from momentum trading for a time because they accept the risk of a calamitous reversal. Yet there also are signs that investors are slow to incorporate new information, or that there is a bandwagon effect for recently fortunate trading strategies. The explanation for the mechanics underlying momentum trading, like the success of the phenomenon itself, remains elusive.