Momentum is a great strategy until it isn’t and the timing of these strategies has not been very accurate especially in a market dominated by risk on, risk off

In the US and Europe a small black bird called a starling will in the evening form large flocks of over a thousand birds. These flocks will move, turn and swirl in amazing coordinated ways. It seems as if their rapid movements might result in collisions but it never happens. Fish in large schools can exhibit similar behaviour. Both the flock and the school can create fantastic ever-changing shapes in a moment and each seem to be exhibiting some sort of incredible collective intelligence and purpose. The reality is that each animal is just reacting according to what it sees in its immediate space without a thought for the larger movement of the flock.

In a similar manner markets across the world will often gyrate from highs to lows in short periods. Certain stocks gain favour or cachet and soar to wildly optimistic price earnings ratios. This is the process of momentum. Often it just seems like a bunch of wildebeests blindly traversing the Serengeti, but there are studies that have determined that the process does actually produce a profit. Since the 1980s, studies have consistently found that stocks which have performed well in the recent past will do so for some time. This effect has been around for much of the 20th century. The effect tends to work for the best performers over the past 12 months, but not for longer periods of three to five years.

This effect seems risky and irrational. If a specific share or even a class of assets performs far beyond its peers or historical norms, it is likely way overvalued. As such eventually the shares may revert to mean in a very dramatic way.

How to pick stocks better

According to one of the most famous or infamous theories in investing—the Efficient Market Hypothesis (EMH)— momentum should not occur. According to the EMH, the price of a financial asset reflects all available information that is relevant to its value. For example if the price of an asset was too low, knowledgeable investors would buy it and make a profit. If a particular stock was overvalued, then the stock would be shorted or sold and it would return to its true value.

One of the main objections to the EMH is that it does not account for bubbles often created by momentum. If a stock has momentum, it could become way overvalued. This usually occurs with high-flying tech stocks. A good example of momentum is the dot.com bubble. A recent example would be Netflix. The stock increased an astonishing 500% over 19 months between January 2010 and July 2011 before returning to near its 2009 valuation in November 2011, four months later.

The real issue with momentum presently is that almost ideally suited to use as a mathematical strategy. Other strategies like value investing, favoured by Warren Buffet, rely on something that theoretically cannot happen in an efficient market, uncovering information that no one else has. But the problem with this method is that finding information, or perhaps more precisely making better assumptions about given information, is not something that can be delegated to a machine. On the other hand machines are very good a watching other machines trade and can determine momentum. As a result it is a favoured strategy of high speed traders who dominate 70% of the market in equities. It is also favoured by quants.

Bonds are risky too, especially in times like now

Momentum almost by its very definition takes advantage of a movement created by other people. To take advantage of this the quants designed strategies that reflected a trend movement. So it is hardly surprising that many of the strategies were very similar. Momentum is at some level irrational. Despite the fact that analysts and pundits are happy to come up with a plethora of reasons why a given stock or asset class should continue to grow, all of these reasons are based on assumptions, some of which are extensions of historical movements. But history does not repeat itself. As they say, momentum is a great strategy until it isn’t and the timing of these strategies has not been very accurate especially in a market dominated by risk on, risk off.

Investors themselves have not helped. With inadequate information about many strategies, they tend to pick money managers who have been successful in the previous quarters. To attract clients money managers eschew a strategy based on analysis of either stocks or economics and herd toward previous winners.

The real flaw in both momentum strategies and EMH has to do with information. EMH assumes that all information is known. This assumes that all players are honest and reveal everything. In contrast, a momentum strategy assumes that the environment will have no impact on the trend. Both assumptions are absurd. One thing that investors can count on is that over time information will provide investors with very large and sometimes very unpleasant surprises.

To read more from William Gamble, please click here.

(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)