Portfolio manager and researcher Dr. Wesley Gray is at it again, looking for ways to build that proverbial better mousetrap.
I reviewed Gray’s previous book, Quantitative Value, which he co-wrote with Tobias Carlisle, and found it to be “solid piece of research that combines the successful value investing framework of Benjamin Graham and Warren Buffett with the analytical rigor seen in Jim O’Shaughnessy’s What Works on Wall Street and Joel Greenblatt’s The Little Book that Beats the Market.”
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Now, Gray’s follow-up book, Quantitative Momentum, aims to apply the same analytical rigor to momentum investing. Gray co-wrote Quantitative Momentum with Jack Vogel, with whom he published DIY Financial Advisor.
Momentum and Value
That these gentlemen have managed to publish two well researched and highly-analytical books in back-to-back years is a feat in and of itself. In my opinion, the book’s biggest contribution to the growing field of research supporting momentum investing is its assertion that momentum and value investing are essentially “two sides of the same behavioral bias coin.”
As Gray and Vogel put it, value investing works because investors systematically overreact to bad news, pushing market prices below intrinsic value. Momentum investing works because investors systematically underreact to good news. So again, both are the products of investor biases.
But, if the value and momentum anomalies are rooted in well-observed biases, then why haven’t smart investors arbitraged the outperformance away? After all, that is what the efficient market hypothesis would suggest.
Gray and Vogel credit two factors:Limits to arbitrage and Investor psychology
Identifying irrational prices is relatively easy. But exploiting them can be tricky due to transactions costs, hence the practical limits of arbitrage. If the cost of exploiting a mispricing is greater than the mispricing itself, the asset can stay mispriced forever.
And, as for investor psychology, the problem here is best summed up with John Maynard Keynes’ observation that “The market can stay irrational longer than you can stay solvent.” Irrational traders may create mispriced assets… but because those traders are irrational and erratic, it can be hard to systematically trade against them.
As Gray and Vogel write, tongue in cheek, “Day traders mess up prices, and although these people are idiots, you don’t know the extent of their idiocy, and you can’t really time the strategy of an idiot anyway, so most smart people don’t even try to take advantage of them.”
Furthermore, while value and momentum strategies have both proven to add significant alpha over the long term, they can massively underperform for years at a time, and professional money managers have careers to manage.
As the authors point out, the legendary Julian Robertson was essentially put out of business in the tech bubble of the late 1990s. As a value investor, Robertson shunned the glitzy growth names driving the market higher and massively underperformed as a result. His clients jumped ship… and buried him.
Warren Buffett might have suffered the same fate had Berkshire Hathaway been a hedge fund or mutual fund rather than a holding company.
So, fear of deviating too far from a “safe” benchmark like the S&P 500 prevents a lot of managers from exploiting value or momentum opportunities. But this also leaves them open for smaller or non-professional investors that don’t face the same constraints.
Gray and Vogel also clarify something that, for a lot of investors, might be somewhat confusing. Momentum investing is distinctly not growth investing.
Growth investing is the opposite of value investing in that growth investors buy stocks that are expensive relative to their earnings, sales, book value or other fundamental criteria. Value investors, of course, buy stocks that are cheap relative to these same fundamental factors.
Momentum investing is a different animal entirely. Momentum merely considers price movements relative to a stock’s history and relative to other stocks. Business or economic fundamentals are not considered at all.
It’s pure price-based technical analysis. In my view, this leads to other possibilities, such as combining value and momentum strategies. A stock can simultaneously be a value stock and a momentum stock if it is both cheap and showing high relative strength.
Gray and Vogel spend much of the rest of the book testing assorted momentum strategies, and while I will spare you the pages of data tables, suffice it to say that, sliced any number of ways, momentum strategies can add serious alpha.
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