Combining Value and Momentum in Stock Selection and Market Timing

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Combining Value and Momentum in Stock Selection and Market Timing

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(Last Updated On: January 18, 2017)

Recently, we wrote two posts about how to combine Value and Momentum for stock selection purposes (Part 1 and Part 2). We followed this piece with a post on combining value and momentum for market timing purposes.

In this post, we review the use of combined Value and Momentum for both stock selection and market timing.

First, let’s examine the combination of Value and Momentum in stock selection. A concept that has been around for many years.

Setting Up a Value and Momentum Portfolio

First, let’s set up the experiment. We will examine all firms above the NYSE 40th percentile for market-cap (currently around $1.8 billion) to avoid weird empirical effects associated with micro/small cap stocks. We will form the portfolios at a monthly frequency with a 3-month holding period — so we use overlapping portfolios, a la Jagadeesh and Titman (1993). We focus on the following 2 variables:

  1. Momentum = Rank firms on three momentum variables: 3-month, 6-month, and 12-month momentum. The average of the 3 ranks is the “momentum” rank.
  2. Value = Rank firms on three value variables: EBIT/TEV, Book-to-Market (B/M), and E/P (inverse of P/E). The average of the 3 ranks is the “value” rank.

Every month, we select the top 100 Value stocks and the top 100 Momentum stocks (and hold them for 3 months). We then equal-weight the holdings.

  1. Value and Mom EW (net) = Top 100 Value firms and Top 100 Momentum firms formed monthly and held for 3 months. Portfolio is equal-weighted. Returns are net of a 1.00% annual management fee and 2.00% annual transaction costs.
  2. SP500 = S&P 500 Total return
  3. LTR = Total Return to Merrill Lynch 7-10 year Government Bond Index
  4. RF = Total Return to Risk-Free Rate (U.S. T-Bills).

Results are net of a 1.00% annual management fee and 2.00% annual transaction costs. Index returns (S&P 500, LTR, and RF) are gross of any fees or transaction costs.  All returns are total returns and include the reinvestment of distributions (e.g., dividends). Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index.

Results (1/1/1964-12/31/2014):

Value and mom 1

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Takeaways:

  • Combining Value and Momentum outperformed the market (after fees) over the past 50 years. However, the Value and Momentum portfolio does have larger drawdowns and higher volatility than the passive index. On a risk-adjusted basis, the combination value/momentum portfolio is favorable.

Interesting, but active equity strategies have drawdown problems.

As previously discussed, we can examine what happens when we overlay a timing signal on top of the combination value and momentum stock selection system outlined above.

Below I describe the two market-timing rules:

Valuation-Based Signal:

We use 1/CAPE as the valuation metric, or the “earnings yield,” as a baseline indicator; however, we adjust the yield value for the realized year-over-year (yoy) inflation rate, by subtracting the year-over-year inflation rate from the rate of 1/CAPE. h.t., Gestaltu. A higher real yield spread is better than a low real yield spread.

To summarize, the metric looks as follows if the CAPE ratio is 20 and realized inflation (Inf) is 3%:

Real Yield Spread Metric = (1/20)-3% = 2%

Some details:

  • Bureau of Labor Statistics (BLS) publishes the CPI on a monthly basis since 1913; however, the data is one-month lagged (possibly longer). For example, the CPI for January won’t be released until February. So when we subtract the year-over-year inflation rate from the rate of 1/CAPE, we do 1-month lag to avoid look-ahead bias.
  • We use the S&P 500 Total Return index as a buy-and-hold benchmark.
  • 80th Percentile Valuation based asset allocation: own Stocks when valuation < 80th percentile, otherwise hold risk-free.
    • In other word, get out of the market if the real yield spread metric is extreme.

Momentum-based signal:

  • Long-term moving average rule on the S&P 500 (own Stocks if above 12-month MA, risk-free if below the 12-month MA).

Using the Combination Signal:

Both signals are calculated using S&P 500 data (momentum and valuation). However, if the signals say we should be invested in stocks, we are invested in the Value and Momentum portfolio.

Results to all portfolios are net of a 1.00% annual management fee and 2.00% annual transaction costs. All returns are total returns and include the reinvestment of distributions (e.g., dividends).

Results (1/1/1964-12/31/2014):

Here we show the results to 4 portfolios:

  1. Value and Mom EW (net) = Top 100 Value firms and Top 100 Momentum firms formed monthly and held for 3 months. Portfolio is equal-weighted. Returns are net of a 1.00% annual management fee and 2.00% annual transaction costs.
  2. Value and Mom EW (Value RM — net) = Top 100 Value firms and Top 100 Momentum firms formed monthly and held for 3 months. Portfolio is equal-weighted. Valuation-based market timing rule applied: Own Stocks (Value and Momentum portfolio) when valuations aren’t extreme, otherwise hold risk-free. Returns are net of a 1.00% annual management fee and 2.00% annual transaction costs.
  3. Value and Mom EW (MA RM — net) = Top 100 Value firms and Top 100 Momentum firms formed monthly and held for 3 months. Portfolio is equal-weighted. Momentum-based market timing rule applied: Own Stocks (Value and Momentum portfolio) if they are above the 12-month MA, own risk-free if below the 12-month MA. Returns are net of a 1.00% annual management fee and 2.00% annual transaction costs.
  4. Value and Mom EW (Value and Mom RM — net) = Top 100 Value firms and Top 100 Momentum firms formed monthly and held for 3 months. Portfolio is equal-weighted. Valuation and Momentum-based market timing rules are applied, each having a 50% signal weight. Returns are net of a 1.00% annual management fee and 2.00% annual transaction costs.
Value and mom 2

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Takeaways:

  • Both the Valuation and Momentum-based market timing rules decreased drawdowns (maximum drawdown and sum of drawdowns).
  • Combining the Value and Momentum market-timing rules yields the lowest drawdown, as well as the highest Sharpe and Sortino ratios.

Conclusion:

Combining Value and Momentum appears to work for both stock selection and market-timing. One can argue that there are “better” ways to combine Value and Momentum. However, a simple approach (documented above) seems to work, at least historically.

There are few caveats that come to mind:

  1. The results above are hypothetical and the future could change.
  2. Valuation-based timing is tough (see introduction of that post) and we’ve cherry picked a system that happens to work in-sample, whereas others we’ve tried don’t seem to work that well.
  3. These systems can drift violently from standard benchmarks (i.e., one needs to be prepared for tracking error)
  4. Value and momentum stocks are much more volatile than a passive index and require a disciplined sustainable investor.

Let us know your thoughts!


  • The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. Our full disclosures are available here. Definitions of common statistics used in our analysis are available here (towards the bottom).
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About the Author:

Jack Vogel, Ph.D., conducts research in empirical asset pricing and behavioral finance, and is a co-author of DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His dissertation investigates how behavioral biases affect the value anomaly. His academic background includes experience as an instructor and research assistant at Drexel University in both the Finance and Mathematics departments, as well as a Finance instructor at Villanova University. Dr. Vogel is currently a Managing Member of Alpha Architect, LLC, an SEC-Registered Investment Advisor, where he heads the research department and serves as the Chief Financial Officer. He has a PhD in Finance and a MS in Mathematics from Drexel University, and graduated summa cum laude with a BS in Mathematics and Education from The University of Scranton.
  • Great work! I’d really like to see a test that builds on the ideas presented here. Is value better for “bottoms”, while momentum is better for “tops”? What if we use the “expensive” value signal to only cut 25% of the exposure (rather than 50%), and let the momentum signal control the remaining 75%. Additionally, what if we add a progressive (or binary, if you like) “cheap” value signal that adds exposure (maybe all the way up to 100%), leaving the momentum signal to only act on the remaining percentage in those conditions. (As the market gets cheaper, the expected return increases. With higher expected returns, shouldn’t we be more tolerant of drawdowns and more worried about taking whipsaw losses?)

  • Jack Vogel, PhD

    Not a bad idea — we may try it out. Thanks for the suggestion!

  • quixoticinvestor

    Great article! Could you clarify the Value and Mom EW (Value and Mom RM — net) strategy? Let’s say the Valuation market timing rule says to get out of stocks. Do you invest in only Top 50 Value and Top 50 MoM? Or do you still invest in Top 100 Value and Top 100 MoM, but at half the amount for each stock? Thanks!

  • Jack Vogel, PhD

    Thanks! We would still invest in the Top 100 Value and Top 100 Momentum, but half the amount.

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