Last week, we discussed consumer data suggesting the economy was weakening. This past week, downward revisions to Q1 GDP and weak personal consumption expenditures (PCE) reports confirmed that suspicion.

The U.S. economy’s growth in the first quarter was revised to an annualized rate of 1.3% from the previously estimated 1.6%, reflecting weaker consumer spending and equipment investment. This slowdown contrasts sharply with the 3.4% growth rate in the final quarter 2023. Inflation for the first quarter was also slightly revised down to 3.3%.

On Friday, PCE, which is roughly 70% of GDP growth, also came in under expectations, adding more concerns to a growing list of economic data that has recently weakened.

In an interesting turn of events, “bad news” seemed to matter to the markets this week. Of course, the reality was that the market was overbought and needed a correction. Wall Street just needed a reason to liquidate some positions.

As noted last week, the 20-DMA crossed above the 50-DMA. On Friday, that support level held, and the market bounced off it, keeping the current consolidation process intact. If the 20-DMA fails, the 50-DMA is the next logical support level. Below is the 100-DMA that provided support during the April correction.

(Click on image to enlarge)

Crucially, the market has now registered a “sell signal,” which will limit any rallies in the near term. Therefore, investors should continue to use bounces to reduce exposure and rebalance portfolios as needed. The upside to the market is likely constrained to recent highs.

While we expect another correction sometime this year, likely before the election, the market will likely provide early warnings of that event. As noted, failures at the 20- and 50-DMA will be such warnings. Also, a failure of the momentum trade that began in November will be worth watching, and it is the subject of this week’s newsletter.

Need Help With Your Investing Strategy?

Are you looking for complete financial, insurance, and estate planning? Need a risk-managed portfolio management strategy to grow and protect your savings? Whatever your needs are, we are here to help.

The Momentum Chase

It is an interesting market environment. Each day, investors parse every piece of economic or financial data for what it may mean to Fed policy. Will the Fed begin cutting rates and restarting monetary accommodation? Such is all that seems to matter. At the same time, investors are chasing higher stocks based on the current theme. In 2020, it was disrupter stocks. Today, it is artificial intelligence and semiconductor providers.

(Click on image to enlarge)

It doesn’t help that media headlines are filled with meaningless commentary while ignoring fundamentals or valuations. In other words, such quaint ideas of buying value have become relics of an age long ago. Of course, this should all be unsurprising.

Today, the markets have evolved into a “get rich quick” industry, where Wall Street creates products to fill hungry investors’ demand for the next “hot opportunity.” Such has been a boon for the index ETF industry, financial applications, and trading websites. As such, the momentum investing issue should be no surprise, given that investors learned to “buy risk” when the Federal Reserve increased monetary accommodation. As discussed previously, the influence of monetary accommodation on asset prices was astounding. To wit:

“The chart below shows the average annual inflation-adjusted total returns (dividends included) since 1928. I used the total return data from Aswath Damodaran, a Stern School of Business professor at New York University. The chart shows that from 1928 to 2021, the market returned 8.48% after inflation. However, notice that after the financial crisis in 2008, returns jumped by an average of four percentage points for the various periods.

After more than a decade, many investors have become complacent in expecting elevated rates of return from the financial markets. However, can those expectations continue to get met in the future?”

(Click on image to enlarge)

“Of course, those excess returns were driven by the massive floods of liquidity from the Government and the Federal Reserve, including trillions in corporate share buybacks and zero interest rates. Since 2009, there has been more than $43 Trillion in various liquidity supports. To put that into perspective, the inputs exceed underlying economic growth by more than 10-fold.”

(Click on image to enlarge)

After more than a decade, investors are now complacent in expecting elevated rates of return from the financial markets. In other words, the abnormally high returns created by massive doses of liquidity became seemingly ordinary. During this decade-long liquidity period, investors developed many rationalizations to chase momentum.

The Potential Problem

Chasing momentum has problems. We will use the following 3-ETFs from 2014 to the present to simplify our analysis. (2014 is the earliest date that all 3-ETFs have performance data.)

• SPDR S&P 500 ETF (SPY) as the “buy and hold” proxy,
• IShares Momentum ETF (MTUM) as the “momentum” proxy; and,
• IShares Value ETF (IVE) as the “value” proxy.

For our analysis, we calculated the growth of $1 invested in each ETF from January 2014 on a nominal capital appreciation basis only. Over that time frame, momentum is the obvious choice for investors compared to the S&P 500 or value.

(Click on image to enlarge)

However, there is a problem with chasing momentum that isn’t readily visible in the chart above. Momentum is a double-edged sword. While momentum provides an advantage in a rising market, it has an obvious disadvantage in a declining market. If we break the comparative performance down into specific periods, the value of the momentum strategy gets lost.

In 2105 and 2016, momentum provided no hedge against the Fed’s “taper” and Brexit.

(Click on image to enlarge)

Similarly, in 2018, relative performance, peak-to-trough, was worse than the benchmark during the Fed’s “taper tantrum.”

(Click on image to enlarge)

Momentum provided little protection during the 2022 correction as the Federal Reserve hiked rates and reduced its balance sheet.

(Click on image to enlarge)

The problem for most investors is that they get swept up in the moment of rising asset prices and the thrill of making money. However, as is always the case, what seems to be working today does not mean it will work indefinitely.

Choosing The Right Strategy At The Right Time

As a strategy, momentum investing works well when correctly applied to a portfolio of individual securities.

“One of the most interesting aspects of this portfolio though is not only that it has a lot of hard numbers backing it up, but that it is in theory accessible to any ordinary investor who can screen stocks by monthly performance.” – Brett Arends

He is correct, and we provide this at SimpleVisor daily, in screens of relative strength, fundamental and technical rankings, and more.

(Click on image to enlarge)

What is crucial is that momentum, as an investing strategy, works exceptionally well in a strongly trending bull market. However, strategies will change during a corrective or bear market cycle. As shown below, market cycles lead the economic cycle. As a result, it should be unsurprising that investment strategies also vary accordingly.

(Click on image to enlarge)

While it may seem like the current advance will continue indefinitely, abandoning decades of investment history would be unwise. As Howard Marks once stated:

“Rule No. 1: Most things will prove to be cyclical.

The realization that nothing lasts forever is crucial to long-term investing. To “buy low,” one must first “sell high.” Understanding that all things are cyclical suggests that investment strategies must also change.

The rotation from “momentum” to “value” is inevitable. It will occur against a backdrop of devastation for investors quietly lulled into the extreme sense of complacency following years of monetary interventions.

“Relative valuations are in the far tail of the historical distribution. If, as history suggests, there is any tendency for mean reversion, the expected future returns for value are elevated by almost any definition.” – Research Affiliates

The only question is whether you will be the buyer of “value” when everyone else is selling “momentum?”

How We Are Trading It

We certainly understand the importance of momentum in relation to portfolio performance. As portfolio managers, we must generate a return for our clients; therefore, we must participate in those stocks that create that performance.

(Click on image to enlarge)

Yes, we realize that the current momentum chase will eventually end. When it does, we must rotate our portfolios from “offense” to “defense.” We continue to monitor the technical analysis of the broad market and sector rotations, which should provide sufficient warnings for making changes accordingly.

(Click on image to enlarge)

However, the market’s current “momentum chase” requires us to maintain exposure to those “Magnificent 7” market members. The recent correction has started to reverse the market’s previous overbought condition, but nothing suggests the bull market trend from November is at risk. Therefore, continue to use corrections and consolidations to add equity exposure as needed.

Our portfolios are well-positioned for the current market environment. However, we will continue managing exposure and risk as needed.

(You can track those portfolios in real time by subscribing to the newly redesigned SimpleVisor platform.)

(Click on image to enlarge)

Have a great week.

More By This Author: