What is “sector momentum” and are we seeing it now?
Maybe you have heard the term momentum. The physics definition of momentum is: the quantity of motion of a moving body, measured as a product of its mass and velocity. Maybe you have heard the phrase “an object in motion tends to stay in motion.” Let’s try to put this in terms relatable to the asset markets for sector momentum. In an article from Clifford S. Asness, Andrea Frazzini, Ronen Israel, and Tobias J. Moskowitz in the Journal of Portfolio Management from the Fall 2014 a simple definition of momentum was laid out. Momentum is the phenomenon that securities that have performed well relative to peers (winners) on average continue to outperform, and securities that have performed relatively poorly (losers) tend to continue to underperform.
According to Ned Davis in Being Right or Making Money, momentum is typically measured as a rate of change, as in the distance an object travels in a given period, or the amount by which stock prices rise or fall in a given time span. A positive value indicates that the price trend is up, and a negative value implies a downtrend.
I will start by saying that I am a momentum advocate. But why? Eugene Fama won a Nobel Prize in 2013 and is considered the father of the Efficient Market Hypothesis which states that asset prices reflect all available information. The implication of EMT is that markets can’t be beat on a consistent, risk adjusted basis. However, Fama has referred to momentum as the “premier market anomaly.” I want to try to take advantage of this anomaly if it is present in the market.
Investors who follow the concept of momentum should focus on the areas of the market that are rising over their time frame (assuming we are talking about the bullish side of the portfolio). I would also argue that investors should add a relative component to the analysis. Not only should they focus on the areas of the market that have positive momentum (that are going up), they should also home in the on the groups that are going up more than the overall market. They should focus on leadership. Momentum investors are not concerned with buying low and selling high, they are interested in buying high and selling higher!
The question is, how can we be sure that sector momentum is going to persist when we are making an investment decision. The short answer is “we can’t” Sorry, there are no sure things in the market. What we can do is look at the data points that tell us if it is likely to persist.
Starting with the basic concept of sector momentum, we will look at the SPDR sector ETFs over a six month time frame. We can see that all of the sectors, other than Energy, have exhibited positive momentum over the past six months. However, only three of the sectors, Technology, Health Care and Communication Services, have rallied by more than the SPY. These are the sectors that have positive sector momentum and are outperforming the broader market.
When looking at these three sectors, we must try to determine if their outperformance is likely to persist. The question is, “how?”
First, all three funds have Very Bullish or Bullish Chaikin Power Gauge ETF ratings. These Ratings combine fundamental and technical analysis. The fundamental component of the ETF’s rating is a function of the Chaikin Power Gauge Ratings of the individual stocks which are holdings of the fund, based on our 20-factor model.
Next, we can look at the ratio of Bullish to Bearish stocks in each fund based on the Power Gauge Rating. In all three of the market leading funds, there are more bullish stocks than bearish stocks.
These are two important data points that increase the odds that these funds could continue to be market leaders. What does this mean for investors? If you are interested in structuring portfolios of ETFs, this can be a great starting point for deciding which funds to include in the portfolio. Perhaps you can develop a strategy that involves owning the top three performing sector funds based on a combination of momentum for your time frame and the ETF rating and reassess leadership at some predetermined time interval (this is not investment advice, merely an example and perhaps a starting point).
For investors who are looking for individual stock ideas to add to the portfolio, using momentum in conjunction with the ETF ratings can help guide you toward leading stocks in leading areas of the market. By leading stocks, we mean stocks with Very Bullish or Bullish Chaikin Power Gauge Ratings that are outperforming the SPY (have strong relative strength).
This is not a call to buy these stocks right now. However, this a good starting point to begin to identify stocks that have the potential to outperform the market over the intermediate term.
We will continue to update this post on a monthly basis to point out the sectors that have been performing the best and, more importantly, have increased odds of continuing to outperform.