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WHITE PAPER
March 2010
Annualized Outperformance
Price momentum has a long history as a successful criticisms that have been raised and considers whether they
stock selection strategy. At GMO we are somewhat carry enough weight to justify abandoning or modifying
neutral parties on momentum. On the one hand, our core the strategy. To start with, a more precise definition of
investing philosophy is one of valuation and reversion to price momentum is in order, as is a survey of the historical
the mean, but on the other, we have been using various evidence that supports the strategy.
forms of momentum since the late 1980s to complement
Figure 1 shows the return relative to the market of portfolios
our valuation-based stock selection strategies. The basic
built by taking the top performing quartile of a large cap
thesis behind momentum investment strategies is that
U.S. investment universe over varying backward-looking
leadership within the market persists for enough time
horizons (both the quartiles and the portfolio weightings
that, on average, one can beat the market simply by
displayed are defined by market capitalization). The
rotating into stocks that have been outperforming. For
strategy here is to rebalance monthly, so the turnover is
value managers, attending to momentum also moderates
somewhat high to implement exactly this strategy, but
the pain that seems to come all too frequently with being
the point is clear. For short horizons like a single month,
both too early to buy and too early to sell. The historical
success of momentum has continued well beyond when
the effect was first documented, and thus the strategy Figure 1
has won widespread, if somewhat grudging, respect and Price Momentum Has an
adoption from investors over the years. It is a mainstay of Impressive History: 1927-2009
quantitatively managed portfolios, but it is also a strategy
Best 25% of Universe
that is indirectly employed by many more fundamental
on Trailing Return
investors.
4%
3%
Short-term
Reversal
2%
1%
0%
-1%
Intermediate-term
Continuation
-2%
-3%
1
11
13
15
As of 12/31/09
Since the explanations for momentum have a whiff of expost justification to them, it is important to note that the
success of momentum is widespread and has persisted
outside the period in which it was originally observed. As
noted earlier, GMO started using momentum strategies in
the U.S. in the late 1980s based on patterns observed from
returns in the 1970s and 1980s. Jegadeesh and Titman
published a much cited study on momentum in 1993.1 In
Figure 3, the left hand bar shows the return to the simple
momentum strategy over the 1970s and 1980s. The 1990s
in the U.S. was an even stronger period that lies outside
of the sample of data used to discover the phenomenon,
and so argues more persuasively that the effect is real. So
also does the outperformance in Europe over that period.
And given that GMO, like many other researchers, did
not have access to older historical data at that time, the
outperformance of momentum in the U.S. over the prior
40 years also serves as an important confirmation. In fact,
by cleverly (or cynically) picking a time period to avoid
the bursting of the internet bubble and the credit crisis,
simple momentum performed quite well in the U.S. for
much of the 2000s.
Figure 2
Because of Short-Term Reversal,
Its Standard to Omit a Month: 1927-2009
Best 25% of Universe on
Trailing Return, Skip One Month
Annualized Outperformance
4%
3%
2%
1%
0%
-1%
1
11
13
15
GMO
As of 12/31/09
Figure 3
Simple Momentum Has a Good Out of Sample Record
Best 25% Simple Momentum
(Last Year's Return ex Most Recent Month)
8%
Annualized Outperformance
7%
6%
5%
4%
3%
2%
1%
0%
U.S.
(70s & 80s)
U.S.
(90s)
Europe
(80s & 90s)
U.S.
(1929-70)
U.S.
(2001-2008)
Figure 4
From a Distance This Looks Pretty Smooth
Best 25% of Market on Trailing Simple Momentum
(Last Year's Return, ex Last Month)
Cumulative (log base 2) Relative Wealth
July 2008
5
Internet
Bubble
4
3
2
1932
Bottom
0
Jan- 27 30 33 36 39 42 45 48 51 54 57 60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05 08
Note: Universe refers to the GMO U.S. large cap investment universe, currently comprised of the top 1,000 U.S. companies by market
capitalization.
Source: GMO, CRSP, Compustat As of 12/31/09
GMO
Commodity Peak
0%
-5%
-10%
-15%
Risk Rally
-20%
Ja
n0
Fe 8
b0
M 8
ar
-0
Ap 8
r-0
M 8
ay
-0
Ju 8
n08
Ju
l-0
Au 8
g0
Se 8
p0
O 8
ct
-0
N 8
ov
-0
D 8
ec
-0
Ja 8
n0
Fe 9
b0
M 9
ar
-0
Ap 9
r-0
M 9
ay
-0
Ju 9
n09
Ju
l-0
Au 9
g0
Se 9
p0
O 9
ct
-0
N 9
ov
-0
D 9
ec
-0
9
-25%
Figure 6
The 00s Were the Weakest Decade for Momentum
As of 12/31/09
Annualized Outperformance
6%
5%
4%
3%
2%
1%
0%
1930s
1940s
1950s
1960s
1970s
1980s
1990s
2000s
Note: Universe refers to the GMO U.S. large cap investment universe, currently comprised of the top 1,000 U.S. companies by market
capitalization.
Source: GMO, CRSP, Compustat As of 12/31/09
GMO
Because
Figure 7
Momentum Has Predicted Earnings Growth
60%
50%
Earnings Growth
40%
30%
20%
10%
Total
0%
Dividend
-10%
-20%
P/E Change
-30%
-40%
-50%
Dec-72
74
76
78
80
82
84
86
88
90
92
94
96
98
00
02
04
06
08
As of 1/31/10
GMO
Figure 8
Performance of Momentum post Reg FD
60%
EAFE ex-Japan
Cumulative Outperformance
50%
40%
30%
U.S.
20%
10%
0%
-10%
Jan-01
02
03
04
05
06
07
08
09
As of 12/31/09
Figure 9
Has Trading Gotten Faster?
2.2
Volume/Market Cap
Detrended for StatArb=50%
Turnover of 200 Largest Mutual Funds
2.0
1.8
1.6
1.4
1.2
1.0
0.8
0.6
0.4
0.2
Dec- 90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
07
08
GMO
09
As of 12/31/09
Figure 10
Momentum Off the 2009 Bottom
Market Peak
10/2007
Market Trough
15%
Momentum vs. Market
10%
5%
0%
-5%
3-Mo. Momentum vs. Market
-10%
-15%
O
ct
N 07
ov
D 07
ec
-0
Ja 7
nFe 08
bM 08
ar
-0
Ap 8
r-0
M 8
ay
-0
Ju 8
n0
Ju 8
l-0
Au 8
gSe 08
p0
O 8
ct
N 08
ov
D 08
ec
-0
Ja 8
nFe 09
bM 09
ar
-0
Ap 9
rM 09
ay
-0
Ju 9
n0
Ju 9
l-0
Au 9
gSe 09
p0
O 9
ct
N 09
ov
D 09
ec
-0
9
-20%
Note: Universe refers to the GMO U.S. large cap investment universe, currently comprised of the top 1,000 U.S. companies by market
capitalization.
Source: GMO, CRSP, Compustat
As of 12/31/09
GMO
Figure 11
Momentum Off Other Historical Bottoms
Market Peak
3/2000
2002
Market Peak
10/2007
Market Trough
30%
20%
10%
Momentum vs. Market
0%
-10%
-20%
-30%
M
ar
-0
0
Ju
l-0
N 0
ov
-0
M 0
ar
-0
1
Ju
l-0
N 1
ov
-0
M 1
ar
-0
2
Ju
l-0
N 2
ov
-0
M 2
ar
-0
3
Ju
l-0
N 3
ov
-0
M 3
ar
-0
4
Ju
l-0
N 4
ov
-0
M 4
ar
-0
5
Ju
l-0
N 5
ov
-0
M 5
ar
-0
6
Ju
l-0
N 6
ov
-0
M 6
ar
-0
7
Ju
l-0
7
-40%
As of 10/31/07
Market Trough
1974
40%
30%
20%
Momentum vs. Market
10%
0%
3-Mo. Momentum vs. Market
-10%
D
ec
-
72
Ap
r-7
Au 3
g7
D 3
ec
-7
3
Ap
r-7
Au 4
g7
D 4
ec
-7
4
Ap
r-7
Au 5
g7
D 5
ec
-7
5
Ap
r-7
Au 6
g7
D 6
ec
-7
6
Ap
r-7
Au 7
g7
D 7
ec
-7
7
Ap
r-7
Au 8
g7
D 8
ec
-7
8
Ap
r-7
Au 9
g7
D 9
ec
-7
9
-20%
As of 12/31/79
Market Trough
1932
20%
10%
0%
3-Mo. Momentum
vs. Market
-10%
-20%
-30%
Momentum
vs. Market
-40%
Se
p-
29
M
ar
-3
Se 0
p30
M
ar
-3
Se 1
p31
M
ar
-3
Se 2
p32
M
ar
-3
Se 3
p33
M
ar
-3
Se 4
p34
M
ar
-3
Se 5
p35
M
ar
-3
Se 6
p36
M
ar
-3
Se 7
p37
M
ar
-3
Se 8
p38
M
ar
-3
Se 9
p39
-50%
As of As of 12/31/39
Note: Universe refers to the GMO U.S. large cap investment universe, currently comprised of the top 1,000 U.S. companies by market
capitalization.
Source: GMO, Compustat, MSCI
GMO
Figure 12
Performance of Momentum Off Market Bottoms
0%
Jun-32
Mar-38
Sep-74
Sep-02
Feb-09
-5%
-10%
-15%
3-Month Momentum
-20%
Momentum
-25%
-30%
Note: Universe refers to the GMO U.S. large cap investment universe, currently comprised of the top 1,000 U.S. companies by market
capitalization.
Source: GMO, CRSP, Compustat
As of 8/31/09
Figure 13
Momentum Does Poorly Off Turning Points
Subsequent Outperformance
6%
4%
2%
0%
-2%
-4%
-6%
-8%
Next 6 Months
-10%
-12%
Off Bottoms
Off Tops
All Periods
GMO
Figure 15
Bear Markets Dont Have Much to Say About the
Future of Momentum
Subsequent 6-Month Outperformance
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
1
10
Figure 14
Bear Markets Are (Perhaps) Bad for Momentum
7%
Subsequent 6-Month Return
of Momentum
Contemporaneous Outperformance
of Momentum
8%
6%
5%
4%
3%
2%
1%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
0%
1
10
GMO
3.0%
10
3%
2%
1%
0%
-1%
-2%
Portfolios based on last
1-15 months return
-3%
Lowest Volatility
2nd Quartile
3rd Quartile
Highest Volatility
11
GMO
Figure 18
A History of Consistent Outperformance, With Occasional Moments of Terror
Performance of Simple Price Momentum*
60%
50%
40%
30%
20%
10%
Average: 4.3%
0%
-10%
Dec 80 Nov 81
-20%
Jul 32 Jun 33
Mar 00 Feb 01
Jul 08
Jun 09
-30%
Dec- 27 30 33 36 39 42 45 48 51 54 57 60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05 08
* Last years 25% best performing stocks ex most recent month.
GMO
As of 12/31/09
Figure 19
Once Bitten, Twice Shy: Momentum Has Done the Best After Its Wipe-Outs
8%
7%
6%
5%
4%
3%
2%
1%
0%
<-20%
-20% to
-10%
-10% to
-5%
-5% to 0%
0% to 5%
>+20%
Dr. Hancock is co-head of the GMO global quantitative equity team and lead manager for international quantitative portfolios.
Disclaimer: The views expressed are the views of Tom Hancock, and are subject to change at any time based on market and other conditions. This is not an
offer or solicitation for the purchase or sale of any security and should not be construed as such. References to specific securities and issuers are for illustrative
purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities.
GMO