The Uncertainty Principle: why momentum matters
Physics buffs will be familiar with Heisenberg’s Uncertainty Principle. For the rest of us, it seemingly states that: the more accurately we can observe a particle’s momentum, the less accurately we can know its position.
In other words, the very act of carrying out certain scientific methods inevitably interferes with the result, defeating the original purpose. It therefore enshrines into science the uncomfortable notion that not everything can be neatly explained by a formula.
Admittedly we, at The Scottish, rarely have discussions on such abstruse aspects of quantum physics. However, ‘momentum’ is something that matters greatly for stockmarkets, and Werner Heisenberg’s thought provoking idea echoes the counter-intuitive way that modern markets behave.
The fashion for formulas
Investing based on opaque formulas is on the rise. A mechanical, mathematical approach is already behind many of the most fashionable investment strategies today and has the superficial appeal that it can be done relatively cheaply, or with the hope of gaining a slight edge over other investors.
Therefore, terms like ‘passive investing’, ‘smart beta’ and ‘factor investing’ are increasingly commonplace. Each of these approaches invests money as dictated by a formula, without regard for the prospects of the business.
It is unclear whether any of these methods will work as hoped in the long run, but they have important implications for the behaviour of stockmarkets in the near-term as they become increasingly influential buyers and sellers of shares.
In the past 10 years, passive funds (which are formulated to mirror a popular index) have doubled their ownership of shares in both the US and the UK. In the US, assets in passive funds outweighed those in active funds for the first time this August.
‘Factor investing’ is another approach that has been particularly influential in recent times. The idea is to break market forces down into component ‘factors’ such as ‘momentum’, ‘value’ and ‘growth’, allowing investors to bet on which will be the dominant force.
However, this sort of ‘scientific’ approach to investment now appears to be having unintended consequences. As more automatic buyers and sellers of shares crowd around the same trades, capital chases the same themes. This interferes with the normal balance of the market – creating a feedback loop that produces bubbles of overpriced shares and pockets of depressed shares.
In effect, it exaggerates the stockmarket trends that it seeks to track. And may well exaggerate the reversal when trends eventually change.
For the past six years, stockmarkets have known little other than ‘momentum’. In other words, stocks that have gone up have continued to go up, and those that have gone down have often remained that way.
Stretched valuations and sometimes shaky corporate governance among some of the biggest winners haven’t slowed this surge in momentum stocks.
Momentum stocks have typically been those of companies perceived as offering high growth – particularly in the technology sector – but, more recently, this has extended to slow-and-steady consumer staples.
The initial rush into growth stocks was a rational response to the low growth environment that has persisted since the end of the financial crisis. But with all the passive, smart beta and factor money backing these stocks, their valuations now look overextended – and their share prices ripe for correction, in our view.
At the same time, ‘value’ has been resolutely out of favour. Value stocks – those that look cheap relative to their underlying financials – have been subdued for an unusually long period.
In September, however, we saw a brief but dramatic shift. The share prices of ‘momentum’ stocks fell sharply, with a corresponding rally in ‘value’. Various explanations were offered by market commentators, but this event reminds us that when trends change, they often take observers by surprise and the speed of change can be rapid.
Many will recall the hasty swing that followed the previous major bull market for growth stocks – the dotcom bubble. Then, a shift back to unfashionable but attractively valued investments caught many investors flat-footed.
Formula based investments may be vulnerable to such sudden moves. If momentum stalls, then these strategies will automatically follow suit.
We believe that this creates an opportunity for active investors who are wary of fashionable trades and prepared to venture where the crowd do not.
Ready for change
We see the greatest risk in situations where many investors are positioned the same way – whether that is mechanical processes that are more aligned than people think, or simply people taking comfort by investing with the crowd. When a crowded trade runs out of steam, the rush towards the exit door can be particularly damaging for investors.
With change often taking investors by surprise, there is much to be said for preparing for a shift. Our portfolio of carefully selected shares in unloved but robust companies is designed to anticipate such change.
So, with so much resting on momentum, we are content to recall the Uncertainty Principle – and remain focused on knowing our positions as accurately as possible.
Please remember that past performance may not be repeated and is not a guide for future performance. The value of shares and the income from them can go down as well as up as a result of market and currency fluctuations. You may not get back the amount you invest.
The Scottish Investment Trust PLC has a long-term policy of borrowing money to invest in equities in the expectation that this will improve returns for shareholders. However, should markets fall these borrowings would magnify any losses on these investments. This may mean you get back nothing at all.