Momentum investing – buying stocks with the strongest recent price moves and earnings growth – has been among the top performing strategies for most of the post-financial-crisis rally.
But in a possible warning of intense equity market volatility to come, that strategy has broken down over the past month.
The FANG stocks – Facebook Inc., Amazon.com Inc., Netflix Inc., and Google parent Alphabet Inc. – have been the most visible successes for momentum investors in recent years but other stocks such as Nvidia Corp. and Microsoft Corp. have also driven outperformance for the strategy.
The iShares Edge MSCI USA Momentum Factor ETF holds a portfolio of stocks weighted toward those with the strongest price momentum. The top holdings are Amazon.com Inc., Microsoft Corp., Visa Inc., Boeing Co., Mastercard Inc., and JPMorgan Chase & Co.
The momentum ETF has richly rewarded investors since its inception in September of 2014. The three-year average annual return of 16.7 per cent easily outdistanced the S&P 500’s average return of 11.9 per cent over the same period. But over the last month, the ETF’s 0.21-per-cent decline trailed the benchmark by a full percentage point.
Momentum investing is a proven strategy over the long term but there’s a big caveat – the temporary portfolio punishment when it stops working is far more severe than for value or growth investors.
As Ian McGugan noted recently in Report on Business Magazine, if you practised momentum investing and rebalanced your portfolio every month, you would have achieved an impressive 11.8 per cent annual average return over the past 16 years. But here’s the catch: You would have lost nearly 64 per cent of your money in 2009 and not fully recovered your losses until 2014.
Netflix Inc., which opened lower by 14 per cent Tuesday after reporting disappointing quarterly results, is the ninth-largest holding in the momentum ETF. Netflix’s stock has endured deep downdrafts before in the past decade and then recovered strongly, but the price volatility provides a warning about what can happen when momentum stocks lose momentum: The bottom drops out.
Technology stocks have provided the lion’s share of gains for the S&P 500 in the first half of 2018, contributing 98 per cent of the total return according to Merrill Lynch chief quantitative strategist Savita Subramanian. This narrowness in the market rally – few companies responsible for almost all the upside – increases the downside risk to the overall index if the tech stocks currently showing upward momentum falter.
Narrow market leadership also means that investors holding S&P 500 index ETFs may be surprised about the extent of volatility if momentum stocks roll over.
It is by no means a foregone conclusion that the success of momentum investing is now over, despite Netflix’s travails. Investors should be aware, however, that the end of the road for momentum stocks, when it does occur, could be a painful ordeal for portfolios.
-- Scott Barlow, Globe and Mail market strategist
This is the Globe Investor newsletter, published three times each week. If someone has forwarded this e-mail newsletter to you, you can sign up for Globe Investor and all Globe newsletters here.
Stocks to ponder
Summit Industrial Income REIT REIT investors are experiencing a much better year than originally anticipated. As a result, Gordon Pape is adding a new REIT to the recommended list of his Income Investor newsletter. Read why here.
The Rundown (For subscribers)
What analysts are predicting for this TSX earnings season
Escalating trade wars, rising interest rates, higher commodity prices, record-high stock prices: There is a lot for investors to chew on as the Canadian second-quarter earnings season kicks off this week. Expectations are relatively upbeat. Analysts anticipate that companies within the S&P/TSX composite index will report profit growth of more than 10 per cent over last year, led by stellar results from energy producers, miners, consumer stocks and technology. But an open question is whether earnings will matter if investors focus instead on what executives say about the impact from tariffs and negotiations over the North American free-trade agreement. David Berman reports
Stop bad-mouthing bonds
So much for the hysteria over bond ETFs getting massacred. There was a point in mid-May when it looked like bonds were going to be a big problem for investors in 2018. And then it passed. Let this be a lesson to all the investors who lost faith in bond exchange-traded funds – you never know what’s ahead in today’s ever-unpredictable financial markets. Read more from Rob Carrick
A buying opportunity in Canada’s renewable energy stocks
It’s too early to know if the new Ontario government will succeed in bringing down electricity rates as it promised during the recent election campaign. But the government sure has brought down stock prices of independent power producers in a hurry, setting up what could be an ideal buying opportunity for investors. Read more from David Berman
CFA Institute adds blockchain to its curriculum
The burgeoning asset class of cryptocurrencies has been given a boost in credibility thanks to the CFA Institute expanding its global curriculum to include courses in blockchain and virtual currencies. Clare O’Hara reports
How Brexit could be a buying opportunity for Canadian investors
Thank goodness for the English football team. Their World Cup heroics allowed Great Britain to think about something other than the growing shambles around Brexit, which started out as a nutty idea and has evolved into a political comedy. Canadian investors should keep a close eye on the continuing spectacle, because it may generate some interesting buying opportunities over the next few months. Ian McGugan shares his thoughts
Don’t hire an adviser based on just low fees
The problem with seeking the lowest-cost investment advice is that you may end up with the lowest-quality advice as well. Rob Carrick explores the issue.
The bond market says to be cared. Should investors fret?
A worrying shift in the United States bond market has sparked a fight among economists and market strategists – a squabble that comes with potentially severe consequences. If the pessimists are proven right, a recession is likely on its way. Tim Kiladze reports
Top Links (for subscribers)
Global investors ‘doing no favours’ for the loonie
Top earnings season stock trade ideas from Goldman Sachs
Others (for subscribers)
How to get the best advice if you’re thinking of buying a rental property
Others (for everyone)
Fund managers view a trade war as the biggest risk to markets since the euro crisis
Why the savviest of emerging market investors aren’t scared of trade wars
Blackrock CEO says trade war could spur broad market rout
Number Crunchers (for subscribers)
Bargain-hunting for strong performers in the Canadian small-cap space
Ask Globe Investor
Question: I would value your opinion on the juggling act of paying down mortgage versus investing in the market at this time, with the intent of selling the principle residence in two to five years.
The upside is a safer investment in the house which, of course, will be a tax-free capital gain at the time of sale, versus the potential for higher returns in the market. But any capital gains are taxed so, like others in my situation, I am scratching my head wondering what to do. – John R.
Answer: Scratch no more. Pay down the mortgage. Stocks are very expensive right now and investors seem to be ignoring the fact that we are living in the most dangerous economic times since the 1930s, thanks to Donald Trump’s trade wars. Yes, there is still some upside potential in stocks, but there is a lot of downside risk. Paying off the mortgage is much the safer route. – G.P.
-Gordon Pape
Do you have a question for Globe Investor? Send it our way via this form. Questions and answers will be edited for length.
What’s up in the days ahead
Elon Musk is sounding more and more like Donald Trump. Both are thin-skinned, eager to lash out at anyone who questions their judgment, and increasingly erratic. How to explain their abrasive behavior? It’s all about our collective willingness to believe in the myth of the great disrupter. Ian McGugan will explain why investors should be wary.
Click here to see the Globe Investor earnings and economic news calendar.
More Globe Investor coverage
For more Globe Investor stories, follow us on Twitter @globeinvestor
Click here share your view of our newsletter and give us your suggestions.
Want to subscribe? Click here to sign up or visit The Globe’s newsletter page and scroll down to the Globe Investor Newsletter.
Compiled by Darcy Keith