Betting on winning stocks still works—for now

  • By Evie Liu,
  • Barron's
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A potential Federal Reserve easing cycle and emerging recession signals might suggest harder times ahead for the economy and for stocks, too—but betting on the winners might work better than expected in a weak economic environment.

The stock market has been tumbling since the Federal Reserve cut the target interest rate on July 31—a signal the central bank is concerned about the current economic cycle.

The bond market is feeling the same way. U.S. Treasury yields have been trending down throughout the year as investors move more money into safer assets. Within a week after the Fed’s rate cut, the 10-year Treasury yield dropped more than 0.3 percentage point (30 basis points) to 1.708% from 2.015%.

Last week, the U.S. government bond market sounded another warning. The 10-year Treasury yield briefly dipped below the 2-year note’s yield for the first time since the financial crisis. The occurrence—referred to as a “yield curve inversion”—is often considered a recession indicator, suggesting that investors’ outlook on the economy is worsening. The Dow Jones Industrial Average (.DJI) shed 800 points when that happened on Aug. 14, the biggest single-day drop since last October.

Even with these headwinds for stocks, there are still opportunities for investors to harvest some handsome gains—by chasing the market’s best performers, or high-momentum stocks, and selling the worst performers.

High-momentum stocks have historically tended to outperform their lagging peers, but by just how much can depend on the macro environment.

Since 1978, when the yield on 10-year Treasuries has been more than 2 percentage points higher than the two-year yield, high-momentum stocks in the U.S. have outpaced the low-momentum group by an average of 3.4 percentage points in the following 12 months, according to a recent note from Oppenheimer analyst Ari Wald.

When the yield gap narrows to less than 1 percentage point, the outperformance went up to 12.6 percentage points. And when the yield curve inverted, high-momentum stocks outran low-momentum ones by an average of 18 percentage points in the 12 months that followed.

We’re already seeing that now. The Dow Jones U.S. Thematic Market Neutral Momentum Index, which buys the market winners and sells the losers monthly, has shot up more than 8% since the July rate cut, while the S&P 500 (.SPX) declined almost 2%.

This might seem somewhat counterintuitive, since the momentum basket is often loaded with cyclical stocks that should, in theory, suffer when the economic outlook weakens. But when things become less certain—with the Fed future policy path still uncertain and the yield curve swinging—buying what has been working seems to be the easiest and—dare we say—safest bet.

“Active investors are now ‘buying what’s working’ more aggressively than usual,” Savita Subramanian, quantitative strategist at Bank of America Merrill Lynch wrote in a July report. “Our 12-Month Price Momentum factor is almost 25% more overvalued on forward earnings than usual, and this basket of stocks with the strongest returns over the last 12 months are, in aggregate, overweight by...institutional long-only investors relative to the benchmark.”

Hedge funds are now more exposed to momentum than they have ever been since mid-2017, according to Bernstein’s Sarah McCarthy.

“Many believe that momentum, a strategy based on buying winning stocks and selling losing stocks, has outperformed over market cycles by taking advantage of conservatism bias—investors typically react slowly to new information to create a steadily-developed trend rather than an efficiently-priced market,” Oppenheimer’s Wald said.

But that also means, at some point in the future, investors will catch up with the new norm and re-examine their positions. As the gap between winners and losers continues to widen, momentum stocks have become increasingly expensive. If sentiment were to shift suddenly and everyone tries to get out, valuations could collapse.

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