Two of the curious anomalies in finance are the value and momentum effects. Simply put, the momentum effect means that the best-performing stocks have had a tendency to keep on rallying and outpace the market. With value, stocks with low valuations have outperformed the rest of the market.
What’s odd is that these two effects seem to run counter to each other. The hottest stocks, one would think, would almost have to be richly valued. How can this be? In the Financial Times, John Authers highlights Paul Woolley, a former fund manager, who thinks he’s threaded the needle.
But first, a few nitpicking points. Authers writes:
Markets are not perfectly efficient. More or less everyone agrees to this in the wake of the financial crisis. And while asset bubbles have recurred from time to time throughout history, bubble production has accelerated sharply.
So not only are markets inefficient, but they are more inefficient than they used to be. This is despite rapid technological improvement to make markets faster and more liquid. So why are markets inefficient, and what can be done about it?
I certainly agree that markets aren’t perfectly efficient. Heck, my website is dedicated to the idea that patient investors can beat the market. But I disagree that bubbles have “accelerated sharply.” True bubbles are fairly rare. The Tech Bubble and the Housing Bubble were very real, but just because prices fall, doesn’t mean any downtrend is a bubble. I would argue that, market wide, stock prices weren’t excessively valued in 2007. Maybe a little high, but nothing crazy,
Furthermore, I don’t see how the supposed proliferation of bubbles means that the market is less efficient. I suspect that the market is actually becoming more efficient, but that’s in a very general sense.
Back to Mr. Woolley, Authors writes:
His intuition is as follows. Funds holding an asset suffer poor returns. This leads to outflows, which force them to sell that asset, creating momentum. It will also lead to “comovement”. As assets flow out of a fund, so all the assets it hold will tend to drop in price. This can extend effects across whole sectors. Eventually, this creates the cheapness that subsequently allows the value effect to prosper.
For an example, look at “value” funds during the tech bubble of the late-1990s. In absolute terms, they kept rising. In relative terms, they performed terribly compared to the booming tech sector, and so much money was pulled from them. This caused value’s underperformance to deepen, and also ensured that the “value effect”, once the inevitable reversal occurred, would be particularly strong.
After much mathematics, the momentum effect proves overwhelming for a matter of some years. And momentum, divorced from the real world fundamentals, leads eventually to bubbles and mispricings.
As I see, he’s saying that the value effect eventually becomes the momentum effect. Honestly, that doesn’t seem right, but I concede that it could be. My hunch is that value and momentum are separate. I think value is mean reversion writ large while momentum is simple greed.
