Buying proven winners has been a market-crushing strategy this year. But one expert says it's gotten too expensive - and has formulated the perfect short bet.
- Sarah McCarthy, a global quant and European equity strategy researcher at Bernstein, advocates for a short position against high-momentum, low-growth stocks.
- Her thesis is built around stretched valuations, a voracious move lower in interest rates, and overweight hedge fund allocations.
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The trend is your friend.
This popular axiom has been adhered to for generations, and suggests an investor buy what's going up while selling what's declining. Don't try to be a hero, just ride the wave.
The momentum approach - formally defined as buying stocks that have performed well over the previous three to 12 months, then selling those that have lagged over the same time period - has outperformed all other styles in the US in 2019, and on a long-short basis is up 11%. It's been an undeniable success.
But Sarah McCarthy, a global quant and European equity strategy researcher at Bernstein, is starting to see cracks developing in the landscape - and she thinks it's setting up a perfect short.
"We are changing our view on Momentum, and specifically stocks which are high Momentum but not high Growth," she wrote in a client note. "These stocks have benefitted from the continuation of the trend of falling bond yields (as Growth stocks have), but this recent acceleration of outperformance seems excessive and overly dependent on a continuation of the current macro path."
She continued: "As a result, we recommend going short the companies that are high Momentum but are not high Growth."
The continuation of the aforementioned macro backdrop is key here. Remember, momentum investors pour into the issues that are already in an established trend, so they rely upon the past to extrapolate into the future.
In today's environment, interest rates seem to be moving in only one direction: lower. Markets and investors alike have simply accepted this notion as law. And we can observe their convictions in real time by analyzing the divergence between growth and momentum strategies.
The chart below shows how momentum stocks became negatively correlated against the 10-year US Treasury bond, while growth stocks remained positively correlated.
Momentum investors are betting heavily that the trend in lower rates will continue, while - as you would imagine - growth investors seem less zealous over the future environment due to worsening fundamentals.
This reinforces McCarthy's view that the outperformance in the momentum factor is largely due to the decline in US Treasury yields. It also leads her to believe that this cohort of stocks is running on fumes, putting upward pressure on valuations.
"Momentum in the US is as expensive as it has ever been on 12m fwd P/E apart from the tech bubble," she said.
The graphs below compares momentum and growth valuations on a price-to-earnings and price-to-book assessment.
Without solid earnings growth, McCarthy is highly skeptical of the momentum strategy. And who could blame her? Eventually the low-rate, sugar-rush will wear off and fundamentals will come back into focus.
With all of that established, McCarthy goes on to demonstrate just what will set her trade's wheels in motion.
"Momentum hates a change in trend," she said. "This could come in various forms (macro or micro), all of which are hard to predict."
Although it seems like interest rates can only go down right now, stranger things have happened. A reversal in rates would unravel momentum positions.
"Analysts have been more pessimistic than normal this year and have been downgrading forecasts at a faster rate than usual, but we still think that there is an intensification of earnings downgrades to come in Sept/Oct," McCarthy concluded.
If you're curious which stocks fit McCarthy's qualification of being high-momentum and low-growth - and should thereby be considered a strong short candidate - here is a sampling of five she identified:
Stay tuned for a full list of single-stock underweight positions suggested by Bernstein.