GMO

WHITE PAPER
March 2010

Momentum – A Contrarian Case for Following the Herd

Tom Hancock

Price momentum has a long history as a successful criticisms that have been raised and considers whether they
stock selection strategy. At GMO we are somewhat carry enough weight to justify abandoning or modifying
neutral parties on momentum. On the one hand, our core the strategy. To start with, a more precise definition of
investing philosophy is one of valuation and reversion to price momentum is in order, as is a survey of the historical
the mean, but on the other, we have been using various evidence that supports the strategy.
forms of momentum since the late 1980s to complement
Figure 1 shows the return relative to the market of portfolios
our valuation-based stock selection strategies. The basic
built by taking the top performing quartile of a large cap
thesis behind momentum investment strategies is that
U.S. investment universe over varying backward-looking
leadership within the market persists for enough time
horizons (both the quartiles and the portfolio weightings
that, on average, one can beat the market simply by
displayed are defined by market capitalization). The
rotating into stocks that have been outperforming. For
strategy here is to rebalance monthly, so the turnover is
value managers, attending to momentum also moderates
somewhat high to implement exactly this strategy, but
the pain that seems to come all too frequently with being
the point is clear. For short horizons like a single month,
both too early to buy and too early to sell. The historical
success of momentum has continued well beyond when
the effect was first documented, and thus the strategy Figure 1
has won widespread, if somewhat grudging, respect and Price Momentum Has an
adoption from investors over the years. It is a mainstay of Impressive History: 1927-2009
quantitatively managed portfolios, but it is also a strategy
Best 25% of Universe
that is indirectly employed by many more “fundamental”
on Trailing Return
investors. 4%

Price momentum has succeeded in the face of a couple of 3%

Annualized Outperformance

intuitive objections. One is that buying winners inherently Short-term

Reversal
conflicts with a contrarian philosophy that is deeply 2%
ingrained within many successful investors. The second
1%
is that the simplicity of analysis needed to build a portfolio
is troubling to adherents of the belief that markets are at 0%
least reasonably efficient. While the skeptics may lurk
in the shadows when the strategy is successful, they are -1%

eager to speak up when momentum fails. And it is hard Intermediate-term

-2% Continuation
for the practitioners of a momentum strategy to launch a
vigorous defense while looking foolish for having recently -3%
lost money with a portfolio of stocks bought simply on the 1 3 5 7 9 11 13 15
basis of having recently gone up. Formation Period (Months)

This paper surveys the state of the world from the Note: Universe refers to the GMO U.S. large cap investment
universe, currently comprised of the top 1,000 U.S. companies by
perspective of a price momentum investor (focusing on market capitalization.
the long-only side of investing). It reviews some of the Source: GMO, CRSP, Compustat As of 12/31/09
there has been reversal, where last month’s winners
underperform the current month’s winners. But as the time
period is extended out to close to a year, the story flips
over. Since 1927, the basket of stocks formed by taking
the winning quartile over the prior 12 months continues to
outperform by an annualized rate of over 3%.
With the desire to sidestep the shorter-term reversal of
fortunes, it is common for students of this momentum
effect to use a measure that omits the return from the
most recent month. Figure 2 shows the return to portfolios
formed over the 1 to 15 most recent months not including
the prior month. The returns peak at 11 months, meaning
the most successful portfolios are formed by taking
the winners over the last 12 months, but excluding the
return from the most recent month. This strategy has
outperformed by nearly 4% per year over the period from
1927-2009. While practitioners all use their own variants
of price momentum strategies, this simple “last 12 months
ex-the most recent month strategy” is a good proxy for the
range of momentum strategies used today.
There has been extensive debate among both practitioners
and academics about why such a simple price momentum
strategy might work. One argument centers about the idea
Figure 2
Because of Short-Term Reversal,
It’s Standard to Omit a Month: 1927-2009
Best 25% of Universe on
Trailing Return, Skip One Month
4%
Annualized Outperformance
3%
2%
1%
0%
-1%
1 3 5 7 9 11
Formation Period (Months)
Note: Universe refers to the GMO U.S. large cap investment
universe, currently comprised of the top 1,000 U.S. companies by
market capitalization.
Source: GMO, CRSP, Compustat
GMO
of slow diffusion of information into the marketplace (so
the early money buying the stocks and creating the price
momentum has effectively better information). Others point
to more behavioral explanations including “disposition
effects” whereby investors are too quick to realize gains
(and loath to realize losses), or pure herding, either by
naïve individuals or somewhat cynical professionals who
are driven by career risk.
Since the explanations for momentum have a whiff of ex-
post justification to them, it is important to note that the
success of momentum is widespread and has persisted
outside the period in which it was originally observed. As
noted earlier, GMO started using momentum strategies in
the U.S. in the late 1980s based on patterns observed from
returns in the 1970s and 1980s. Jegadeesh and Titman
published a much cited study on momentum in 1993.1 In
Figure 3, the left hand bar shows the return to the simple
momentum strategy over the 1970s and 1980s. The 1990s
in the U.S. was an even stronger period that lies outside
of the sample of data used to discover the phenomenon,
and so argues more persuasively that the effect is real. So
also does the outperformance in Europe over that period.
And given that GMO, like many other researchers, did
not have access to older historical data at that time, the
outperformance of momentum in the U.S. over the prior
40 years also serves as an important confirmation. In fact,
by cleverly (or cynically) picking a time period to avoid
the bursting of the internet bubble and the credit crisis,
simple momentum performed quite well in the U.S. for
much of the 2000s.
Figure 4 shows the cumulative outperformance of the
simple momentum portfolio over time. The magic of
compounding has lifted it to a level of wealth nearly 32
(2^5) times that of the broad market. This chart, however,
compresses over 80 years of history onto a single page in
a way that obscures some details of volatility that seem
rather more interesting when one lives through them. There
are a number of rather significant divots in that graph, with
the one freshest in our minds being the collapse off the
peak in the summer of 2008 (the main event being the
prices of commodity-oriented companies peaking to the
detriment of momentum strategies that had dialed into
13 15
those stocks).
1 Jegadeesh, Narasimhan and Titman, Sheridan, Momentum (October 23,
2001). University of Illinois Working Paper. Available at SSRN: http://ssrn.
com/abstract=299107 or doi:10.2139/ssrn.299107
As of 12/31/09
2 Momentum – A Contrarian Case for Following the Herd – March 2010
 Figure 3
Simple Momentum Has a Good “Out of Sample” Record

Best 25% Simple Momentum

(Last Year's Return ex Most Recent Month)
8%

7%
Annualized Outperformance

6%

5%

4%

3%

2%

1%

0%
U.S. U.S. Europe U.S. U.S.
(70s & 80s) (90s) (80s & 90s) (1929-70) (2001-2008)

Source: GMO, Compustat, CRSP, MSCI

Figure 4
From a Distance This Looks Pretty Smooth

Best 25% of Market on Trailing Simple Momentum

(Last Year's Return, ex Last Month)
6
Cumulative (log base 2) Relative Wealth

July 2008
5
Internet
Bubble
4

3
1932
2
Bottom

0
Jan- 27 30 33 36 39 42 45 48 51 54 57 60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05 08

Note: Universe refers to the GMO U.S. large cap investment universe, currently comprised of the top 1,000 U.S. companies by market
capitalization.
Source: GMO, CRSP, Compustat As of 12/31/09

Momentum – A Contrarian Case for Following the Herd – March 2010 3 GMO
Figure 5 zooms in on that window of recent momentum The effect of this turn in momentum’s fortunes was to
performance, indexed to 0% at the peak of relative wealth. wipe out the gains the strategy had achieved over the
In the course of roughly a year from the summer of 2008, decade of the 2000s. Breaking down the returns to simple
simple momentum was battered and lost nearly a quarter momentum by calendar decade, Figure 6 shows that the
of its value relative to the market. After the commodity 2000s closed as the worst period for momentum investing
peak, momentum limped through the collapse of Lehman in our data history. One explanation is to write this off as an
Brothers in September 2008, and then was most severely accident of timing given that the decade began and ended
damaged when there was a near complete reversal of with extreme reversal events and the bursting of bubbles.
market leadership at the market bottom with the rebound But momentum is an approach with which many investors
in riskier assets starting in March 2009. are uncomfortable, and has thus come under assault. The
objections around momentum are reminiscent of the late
90s when value investing was dismissed as a relic from
Figure 5
the past.
Since Mid-2008 Momentum Has Been Crushed

5%
Commodity Peak
Cumulative Relative Performance

0%

-5%

-10%

-15%
Risk Rally
-20%

-25%
Ap 8

Ap 9
Ju 8

Ju 9
D 8

D 9
Fe 8

M 8

M 8

08

Au 8

Se 8

O 8
N 8

Ja 8

Fe 9

9
M 9

M 9

09

Au 9

Se 9

O 9
N 9
-0

-0
-0

-0

-0

-0
0

r-0

l-0

0
-0

-0

-0
0

r-0

l-0

0
-0
n-

b-

n-

g-

p-

n-

b-

n-

g-

p-
ar

ar
ay

ay
ov

ov
ct

ct
ec

ec
Ju

Ju
Ja

Source: GMO, CRSP, Compustat As of 12/31/09

Figure 6
The 00s Were the Weakest Decade for Momentum
Subsequent Performance of Last Year's Winners (ex Most Recent Month)
7%

6%
Annualized Outperformance

5%

4%

3%

2%

1%

0%
1930s 1940s 1950s 1960s 1970s 1980s 1990s 2000s
Note: Universe refers to the GMO U.S. large cap investment universe, currently comprised of the top 1,000 U.S. companies by market
capitalization.
Source: GMO, CRSP, Compustat As of 12/31/09

GMO 4 Momentum – A Contrarian Case for Following the Herd – March 2010
 The main criticisms of momentum that we have heard are this criticism, it is important to realize how it is that
as follows: momentum portfolios outperform. Figure 7 shows the
rolling 36-month outperformance of simple momentum
Because of the adoption of Regulation Fair Disclosure
across time. When one buys a stock one can think of
(Reg FD) in the U.S. in October 2000, companies no
getting returns in three ways: to be paid a dividend, or
longer release information early to analysts, which
is a key component to why there was historically a to receive a capital gain either because earnings grow or
slow dissemination of information about changes in a because the price multiple (P/E ratio) assigned to those
company’s fundamentals into the market. earnings expands. For momentum stocks in particular the
cumulative return relative to the market is broken down
Because investors turn over their portfolios at a much in this figure. The salient point is that momentum stocks
higher rate than the historical norm, the speed at which consistently outgrow the market by a significant amount.
information spreads across the market is much higher
(or perhaps vice-versa). Thus the activity that occurred Markets are actually somewhat efficient in this way, and
historically within 12 months is now compacted into a so the price gain that momentum stocks have enjoyed to
much-compressed window, and so if any momentum generate the momentum has driven them to almost the
works it will have a much shorter time horizon. appropriate valuation premium. Specifically, most of that
earnings growth is offset by subsequent contraction of the
Perhaps momentum works in “normal” times, but given P/E ratio, so the stock price stays just slightly ahead of
the market collapse, or the volatility of the market, or the market. Given that momentum stocks are almost by
other indicators, investors should have known tactically definition more expensive than the average, it is critical
either to de-emphasize momentum or to shorten its that they outgrow the market. The concern about Reg FD
investment horizon at various points over the last year. is effectively that momentum stocks will no longer deliver
There are too many “Quant” managers using too much that growth. However the data does not bear that out.
leverage, and so the amount of investment dollars Momentum stocks have continued to outgrow the market
thrown at momentum strategies is too great for continued by an amount close to their traditional 15% to 20% level.
success.
Perhaps a more direct response to the Reg FD critique is
The remainder of this paper addresses these various points, the performance of momentum in non-U.S. equity markets.
starting with the concern about Reg FD. To understand Reg FD is a U.S. regulation applying to U.S. companies.

Figure 7
Momentum Has Predicted Earnings Growth
Contribution to Rolling 36-Month Relative Return

60%
50%
Earnings Growth
40%
30%
20%
10%
Total
0%
Dividend
-10%
-20%
P/E Change
-30%
-40%
-50%
Dec-72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08

Source: GMO, Compustat As of 1/31/10

Momentum – A Contrarian Case for Following the Herd – March 2010 5 GMO
A quick glance at the performance lines in Figure 8 shows traded as a fraction of total market capitalization has
that the performance of momentum since 2001 is very increased significantly over the period in which momentum
similar in the U.S. and other developed international has failed. There is a difference between average and
markets (omitting Japan). Given this similar effect, it does typical holding periods, however. And this volume data
not appear to us that the forces in effect that have battered includes an increasing amount of short-term trading for,
momentum are the creation of a U.S. regulator. e.g., derivative hedging activities and high frequency
The second criticism of momentum is that a speed-up of statistical arbitrage strategies where positions are typically
equity market trading had likely changed how markets closed out within the day if not within seconds. Such
function. Indeed, as shown in Figure 9, the value of shares short-horizon strategies have no obvious interaction with

Figure 8
Performance of Momentum post Reg FD
60%
EAFE ex-Japan
50%
Cumulative Outperformance

40%

30%
U.S.
20%

10%

0%

-10%
Jan-01 02 03 04 05 06 07 08 09

Source: GMO, Compustat, MSCI As of 12/31/09

Figure 9
Has Trading Gotten Faster?
2.2
2.0 Volume/Market Cap
Fraction of Shares Traded per Month

Detrended for StatArb=50%

1.8
Turnover of 200 Largest Mutual Funds
1.6
(Indexed to 1/2001)

1.4
1.2
1.0
0.8
0.6
0.4
0.2
Dec- 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09
Source: GMO, Compustat, Factset As of 12/31/09

GMO 6 Momentum – A Contrarian Case for Following the Herd – March 2010
 longer-term price momentum. Estimates of statistical
arbitrage volume are as high as 70% of trading. If we de-
trend the growth in volume for an estimated growth of up
to 50% of market volume, the speeding up of “normal”
trading is much less frightening. To get at that measure
in another way, we studied 13-F filings from the 200
largest U.S. mutual funds and from these estimated the
average turnover of those portfolios. Again, for these
large institutional portfolios there is no clear trend toward
persistent higher levels of trading.
The notion that momentum should be implemented on a
shorter time horizon has no doubt been boosted by the
relatively smooth passage that shorter-term momentum
strategies enjoyed through the recent turbulence. Figure
10 contrasts the performance of simple momentum (12-
month return excluding the most recent month) with a
momentum measure based on just 3 months of return. The
relative returns are indexed to 0 at the market trough. The
shorter-term version of momentum has not performed well
historically (see Figure 1). But it held up impressively
well by comparison as the market thrashed around over
the past year.
Unfortunately, that relatively robust performance is unique
to the 2009 bottom. Figure 11 shows the same return off of
other historical bottoms following severe market declines.
The shorter-term measure did not perform better off of the
2002, 1974, or 1932 bottoms. Figure 12 summarizes these
results. It would require quite a leap of faith to conclude
that a shorter-term momentum strategy is better than a
longer-term measure.
It is apparent that both momentum portfolios suffered off of
all these market bottoms. That is a somewhat unsurprising
observation given that momentum is a trend following
strategy, and market bottoms are by definition turning
points. If it is clear that the market is at a bottom it seems
unwise to pursue a momentum strategy. But an investor
who can clearly see that the market is at a bottom today
has little need to be bothered with esoteric second-order
stock selection strategies in order to be successful!
Of course it is only clear that the market has bottomed
after the fact. So the more relevant question for an investor
hoping to identify an indicator applicable to timing
momentum is whether the fact that there was recently a

Figure 10
Momentum Off the 2009 Bottom
Market Peak
10/2007 Market Trough
15%
Momentum vs. Market
10%
Momentum vs. Market

5%

0%

-5%
3-Mo. Momentum vs. Market
-10%

-15%

-20%
Ap 9
Ap 8

Ju 9
Ju 8

D 08

D 09
D 07

M 09

Ju 9
Au 9
Se 09

O 9
N 09

9
N 07

Ja 7
Fe 08

Se 08

O 8
N 08

Ja 8
Fe 09
M 09
M 08

M 8

Ju 8
Au 8

-0
-0

-0
-0

0
l-0

-0
-0

r-0

0
l-0

-0
-

-
-

r-

n-

g-
p-

-
-

n-
b-

n-

g-
p-

n-
b-
ar

ar

ay
ay

ov

ov
ov

ct

ct
ct

ec

ec
ec
O

Note: Universe refers to the GMO U.S. large cap investment universe, currently comprised of the top 1,000 U.S. companies by market
capitalization.
Source: GMO, CRSP, Compustat As of 12/31/09

Momentum – A Contrarian Case for Following the Herd – March 2010 7 GMO
Figure 11
Momentum Off Other Historical Bottoms
Market Peak Market Peak
3/2000 Market Trough 10/2007
2002 30%

20%
3-Mo. Momentum vs. Market
Momentum vs. Market

10%
Momentum vs. Market
0%

-10%

-20%

-30%

-40%
0

7
M 0

M 1

M 2

M 3

M 4

M 5

M 6
N 0

N 1

N 2

N 3

N 4

N 5

N 6

7
-0

-0

-0

-0

-0

-0

-0

-0
-0

-0

-0

-0

-0

-0

-0
l-0

l-0

l-0

l-0

l-0

l-0

l-0

l-0
ar

ar

ar

ar

ar

ar

ar

ar
ov

ov

ov

ov

ov

ov

ov
Ju

Ju

Ju

Ju

Ju

Ju

Ju

Ju
M

As of 10/31/07
Market Trough
1974 40%

30%
Momentum vs. Market

20%
Momentum vs. Market
10%

0%
3-Mo. Momentum vs. Market
-10%

-20%
72

Au 3

D 3
3

Au 4

D 4
4

Au 5

D 5
5

Au 6

D 6
6

Au 7

D 7
7

Au 8

D 8
8

Au 9

D 9
9
r-7

-7

r-7

-7

r-7

-7

r-7

-7

r-7

-7

r-7

-7

r-7

-7
-

g-

g-

g-

g-

g-

g-

g-
ec

ec

ec

ec

ec

ec

ec

ec
Ap

Ap

Ap

Ap

Ap

Ap

Ap
D

As of 12/31/79
Market Trough
1932 20%

10%
Momentum vs. Market

0%
3-Mo. Momentum
-10%
vs. Market
-20%
Momentum
-30%
vs. Market
-40%

-50%
Se 0

Se 1

Se 2

Se 3

Se 4

Se 5

Se 6

Se 7

Se 8

Se 9
29

30

31

32

33

34

35

36

37

38

39
-3

-3

-3

-3

-3

-3

-3

-3

-3

-3
p-

p-

p-

p-

p-

p-

p-

p-

p-

p-

p-
ar

ar

ar

ar

ar

ar

ar

ar

ar

ar
Se

As of As of 12/31/39
Note: Universe refers to the GMO U.S. large cap investment universe, currently comprised of the top 1,000 U.S. companies by market
capitalization.
Source: GMO, Compustat, MSCI

GMO 8 Momentum – A Contrarian Case for Following the Herd – March 2010
 Figure 12
Performance of Momentum Off Market Bottoms
Jun-32 Mar-38 Sep-74 Sep-02 Feb-09
0%
Subsequent 6-Month Relative Return

-5%

-10%

-15%
3-Month Momentum
-20%
Momentum

-25%

-30%
Note: Universe refers to the GMO U.S. large cap investment universe, currently comprised of the top 1,000 U.S. companies by market
capitalization.
Source: GMO, CRSP, Compustat As of 8/31/09

market bottom is informative. Figure 13 shows two sets of There is no meaningful difference in the strategy’s success
returns. The first set is the relative performance of simple following the identification of a bottom from the normal
momentum for the 6 months following one of the major environment. This analysis can be viewed as revealing
market bottoms (e.g., most recently March 2009-August a glass either half full or half empty. The good news is
2009 and October 2002-March 2003), the 6 months that data suggests these turns don’t “break” momentum.
following the intermediate market tops, and finally in other The bad news is that the strategy has just suffered a major
periods. This confirms the observation that momentum drawdown (on average losing nearly 11% off the market
does badly at turns. But more relevant is the second set bottom), and yet a patient investor does not get this return
of bars showing how momentum fares in the subsequent back. This is in marked contrast to value-based strategies
three years (e.g., April 2003-March 2006). We choose a where underperformance typically leads to an abnormally
longer period with the idea that the question on the table is wide spread of valuations and a recovery of that loss as
whether a strategic shift away from momentum is in order. spreads revert to a normal level. The difference is that a
momentum portfolio rotates its holdings more frequently,
so the portfolio that subsequently wins doesn’t include
Figure 13 the abandoned losers. And their loss is a sunk cost. It
Momentum Does Poorly Off Turning Points doesn’t mean an investor should abandon the strategy,
6% but it requires a certain fortitude not to lose patience in a
4% strategy that has disappointed without the promise of future
Subsequent Outperformance

outsized returns as consolation. And in an investing world

2%
where portfolios are typically managed by professionals
0% with a keen sense of career risk, it is a real and significant
-2% drawback to lose with momentum and be left with relatively
-4% weak ammunition with which to exhort clients to stay the
course in order to enjoy the potential opportunities.
-6%
-8% Next 6 Months
Returning to the issue of timing momentum, consider
-10%
some of the folk wisdom on the utility of certain signals
3 Years After That
to time momentum. We have seen that major tops and
-12%
bottoms in the market are not of much use as a forecasting
Off Bottoms Off Tops All Periods
tool. And other techniques also suffer the flaw of being
Source: GMO, Compustat, CRSP coincident indicators for when momentum isn’t working

Momentum – A Contrarian Case for Following the Herd – March 2010 9 GMO
without revealing much about whether momentum is Figure 15
going to work. Bear Markets Don’t Have Much to Say About the
Future of Momentum
Figure 14 shows the return to the simple momentum
strategy over 12-month periods broken out by the level 3.5%

Subsequent 6-Month Outperformance

of overall market return. So, for example, in the 10%
worst rolling 12-month periods, momentum on average 3.0%
outperformed by a bit under 3%. There is perhaps some 2.5%
suggestion that momentum does better in stronger markets
than weak markets, which would be intuitive given its 2.0%
success comes through above average growth. (Even 1.5%
that is a bit suspect as survivorship bias is a factor in our
investment analyses taking place in a world in which 1.0%
bear markets tend not to last for many years in a row.) 0.5%
But this is a coincident indicator. Figure 15 shows the
same breakdown of market returns, and then shows how 0.0%
momentum performs in the next 6 months. The level of 1 2 3 4 5 6 7 8 9 10
market returns is not a useful forecasting indicator. Decile of 12-Month Market Return

Japan is the one major market where price momentum
has not been effective. During the long bear market,
there have been many head fakes and rapid reversals
that have led to the general failure of longer-term trend
following strategies (and the success of mean reversion
strategies). If one fears as some do that the U.S. equity
market is heading the way of Japan, the implications are
negative for momentum. But firstly that requires getting
that macro forecast correct, and secondly there are other
examples of decade-long dry spells for equity markets in
Figure 14
Bear Markets Are (Perhaps) Bad for Momentum
8%
Contemporaneous Outperformance
Note: Universe refers to the GMO U.S. large cap investment universe,
currently comprised of the top 1,000 U.S. companies by market
capitalization.
Source: GMO, Compustat, CRSP
which momentum did well (the 1930s and 1970s), so the
resemblance to Japan would have to be quite precise.
Another class of indicator that has been put forward as
relevant is the level or change in the level of volatility.
Figure 16 shows the relationship between cross-sectional
Figure 16
Level of Trailing Volatility Is Not Compelling for
Timing Momentum
3.5%

7%
3.0%
Subsequent 6-Month Return

6%
2.5%
of Momentum

of Momentum

5%
2.0%
4%
1.5%
3%
1.0%
2%

1% 0.5%

0% 0.0%
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
Decile of 12-Month Market Return Decile of Market Volatility

Note: Universe refers to the GMO U.S. large cap investment Note: Universe refers to the GMO U.S. large cap investment universe,
universe, currently comprised of the top 1,000 U.S. companies by currently comprised of the top 1,000 U.S. companies by market
market capitalization. capitalization.
Source: GMO, Compustat, CRSP Source: GMO, Compustat, CRSP

GMO 10 Momentum – A Contrarian Case for Following the Herd – March 2010
 volatility in the market and future momentum returns
(admittedly there are many ways of measuring volatility;
the one used here is a 6-month average of the cross-
sectional standard deviation of monthly returns). The
connection is hardly convincing. Contemporaneously,
volatility is bad for momentum, largely because volatility
is associated with mean reversion and not trending. And
if one can predict volatility or predict a bear market, that
no doubt has power predicting whether momentum will
succeed. But the ability to make those calls with some
precision about the timing is a skill that allows one to
profit in simpler ways.
One final point on timing a momentum strategy is that
some have claimed that investors should respond to
higher volatility by shortening the horizon of momentum,
presumably with the intuition that in a volatile environment
things are happening more quickly and one needs to be
nimble. In fact, the evidence does not suggest this. Figure
17 shows the return to trailing n-month return (here without
skipping the most recent month) broken down by different
levels of trailing market volatility. When volatility is high,
there is more short-term reversal (and more mean reversion
in the markets in general). The power of momentum still
shines through the fog, but one needs to use a longer
Figure 17
If Anything, You Should LENGTHEN the Signal
3%
Subsequent 6-Month Outperformance of
2%
Best 25% Trailing Return
1%
0%
-1%
-2%
Portfolios based on last
1-15 months’ return
-3%
Lowest Volatility
Note: Universe refers to the GMO U.S. large cap investment universe, currently comprised of the top 1,000 U.S. companies by market
capitalization.
Momentum – A Contrarian Case for Following the Herd – March 2010
version where the short-term thrashing around is less
significant. Essentially, the problem with volatility is that
the noise to signal ratio in returns is higher, so more data
is needed to smooth that. If anything, one should lengthen
a momentum signal.
So where does that leave us? The more technical
explanations for momentum breaking from Reg FD and
faster trading do not seem to withstand scrutiny. And in
any case, momentum has worked fairly well over the last
decade if one excludes the big events in 2000 and 2009.
The final criticism that momentum has become a crowded
trade is one that we take more seriously. There is clearly
some limit to how much money can be thrown at this
strategy before momentum stocks become too expensive
to justify their superior prospects (or where all the return
chasers have exhausted their capital). The good news is that
the returns to momentum over the last decade are wholly
as might be expected given what happened with markets
in general, and do not show a slow erosion. Even if that
erosion were occurring, it has been at least temporarily
arrested as quantitative managers have significantly
reduced leverage and clients have reduced exposure to
quantitative managers.
2nd Quartile 3rd Quartile Highest Volatility
Quartile of Market Volatility
Source: GMO, Compustat, CRSP
11 GMO
While the capacity of momentum may be freeing up, the
conclusion is that momentum is and always will be a very
uncomfortable strategy to run. When it breaks, one is
left without special hope of getting additional return, and
one is forced to justify a strategy that on the surface of
it sounds rather naïve. Figure 18 shows the rolling 12-
month returns to the momentum portfolio over the longer
term. While the average outperformance is significant, it
comes at the cost of occasional large drawdowns that can
be very injurious to a professional money manager. It is
a painful way to lose. And fundamentally, it is the ability
to bear that pain for which momentum investors are
rewarded. GMO’s approach to maximizing the benefits of
momentum per unit pain (where we use it at all) is to keep
momentum as a relatively small diversifying element for
more fundamentally oriented strategies.
As somewhat scant evidence given the lack of data
points, Figure 19 shows the longer-term returns to a
momentum strategy following its wipe-outs. When
momentum has failed the most and presumably fallen out
of favor (or investors have shied away from managers
with trend-following approaches) is when momentum
has subsequently done the best. The number of events at
the extremes is small, but the message is intuitive. While
momentum involves buying stocks that are individually
the most popular, the willingness to follow this strategy
is becoming increasingly contrarian. And that we see as a
necessary advantage for it to work.

Figure 18
A History of Consistent Outperformance, With Occasional Moments of Terror

Performance of Simple Price Momentum*

60%

50%
Rolling 12-Month Outperformance

40%

30%

20%

10%
Average: 4.3%
0%

-10%
Dec ‘80 – Nov ‘81 Jul ‘08 –
-20%
Jul ‘32 – Jun ‘33 Mar ‘00 – Feb ‘01 Jun ‘09
-30%
Dec- 27 30 33 36 39 42 45 48 51 54 57 60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05 08

* Last year’s 25% best performing stocks ex most recent month. Source: GMO, Compustat, CRSP As of 12/31/09

GMO 12 Momentum – A Contrarian Case for Following the Herd – March 2010
 Figure 19
Once Bitten, Twice Shy: Momentum Has Done the Best After Its Wipe-Outs

8%
Next 5-Year Outperformance of Momentum

7%

6%

5%
(Annualized)

4%

3%

2%

1%

0%
<-20% -20% to -10% to -5% to 0% 0% to 5% 5% to 10% 10% to 20% >+20%
-10% -5%
Trailing 12-Month Performance of Momentum

Source: GMO, Compustat, CRSP

Dr. Hancock is co-head of the GMO global quantitative equity team and lead manager for international quantitative portfolios.

Disclaimer: The views expressed are the views of Tom Hancock, and are subject to change at any time based on market and other conditions. This is not an
offer or solicitation for the purchase or sale of any security and should not be construed as such. References to specific securities and issuers are for illustrative
purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities.

Copyright © 2010 by GMO LLC. All rights reserved.

Momentum – A Contrarian Case for Following the Herd – March 2010 13 GMO