After all the noise in the market quiets down each day, I like to gauge sentiment. And I’ve consistently noticed that bears and bulls blame momentum for everything.
But is there any edge to it? Does momentum actually help your trading?
Last week, I introduced the concept of trading “factors.” Factors are segments of the market that slice and dice various fundamental forces – momentum being one of them.
As you can see from the chart below, momentum alone is a zero-edge strategy.
This chart shows the S&P 500 Momentum Index. It measures the effect of going long on the top 20% of stocks in the S&P 500 (ranked by 12-month returns) and shorting the bottom 20%, rebalanced monthly.
Since 2002, it has returned -56%.
That certainly doesn’t look like an edge.
So you maybe asking,“If momentum doesn’t give traders an edge, why use it?”
The answer is the value it brings to market intelligence.
Abrupt breakdowns in this factor coincide with abrupt macro regime shifts, like in March 2009 after the Great Financial Crisis and even the big market reversal we saw this year.
As long as momentum has, well, momentum, then the current market conditions will likely continue. And when it breaks down, the market shifts to a new theme.
Because when momentum breaks down, price reversion becomes the dominant theme. We can see that when we zoom in on the last 12 months.
It explains the plight of both bulls and bears. (Or as I like to call them, “the opinionated.”)
Momentum was carrying along fine until November when it abruptly spiked down.
Even though the market as a whole was still weak at the end of the year, there was already a seismic shift underway below the surface.
You could no longer simply short tech and buy sectors like energy. That strategy began to fade. And by January, it was obliterated. The entire momentum trade from 2022 unraveled within a month.
Momentum picked up again this year, as the composition of the momentum basket changed.
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More recently, though, momentum is receding again. The tide hasn’t fully shifted yet, but it’s threatening to do so.
That tells us something is about to shift in the market.
That’s useful information, of course, but it’s not specific enough to give us an edge with trading. Yet if momentum alone doesn’t give us an edge, what’s another factor that will?
When we look at the “R&D to Sales” factor, we see something else interesting.
As the name implies, this ranks the S&P 500 stocks based on their percentage of revenue that’s reinvested into research and development (R&D).
Notably, the top-ranked R&D to Sales stocks have been obliterated this year while the tech-heavy Invesco QQQ Trust Series 1 (QQQ) is up 38.6%.
Right now, it’s peppered with biotech stocks.
This is a surprise because biotech stocks are high beta plays that have fallen in the recent rising market. Companies like Incyte (INCY) and Moderna (MRNA) were trading below even the most bearish of Wall Street estimates up until recently.
So, this is another sign that they may soon start catching a bid.
From an intuitive point of view, R&D to Sales is a factor of long-term dominance.
These companies make enough money and have the confidence to plow cash back into the business to research and innovate. Eventually, that investment pays back in large multiples.
Think of Amazon (AMZN) back when analysts were upset over its lack of cash flow and Bezos didn’t care. As Harvard Business Review put it, he “trained… the investment community to expect that low profits (or big losses) now represent investments that will eventually pay off.”
So using factors like these, we can spot trends in the market that are worth paying attention to. Biotech should be on our radar in the coming weeks.
Regards,
Eric Shamilov
Analyst, Trading With Larry Benedict