Markets

Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

Guess what? For the first time in six years, value stocks are on track to edge out momentum stocks.

As my Bloomberg News colleague Oliver Renick put it, “It’s been a great year for catching falling knives.” Renick is alluding to value investors' fear of grabbing a plummeting stock, only to watch its price plummet further.

Value Strikes Back
After six years of under-performance, value is getting the better of momentum this year.
SOURCE: Bloomberg

Renick and Bloomberg analyst Kevin Kelly created a simulated trading strategy that buys the most beaten-down U.S. stocks each week. They appropriately named it the Weekly Oversold Index, and it has handily outperformed the broad market so far this year.

Renick and Kelly's work also highlights why it pays to open up the market's hood from time to time and see how the engine is actually running. While the broad market – as most commonly measured by the S&P 500 – gets all the headlines and attention, just under the surface the forces of value and momentum are churning away, each trying to outpace the other.

When a stock declines, only one of two things can happen next: it will reverse course or it will continue to fall. Buying is a bet that the stock will recover (the value play); selling is a bet that the stock will continue to decline (the momentum play). This concept is the same, by the way, whether prices move up or down, and applies to all assets, not just stocks.

Momentum's Mojo
Momentum has beaten value for six consecutive years from 2010 to 2015.
SOURCES: MSCI, Bloomberg

In theory, value investors should zig when momentum investors zag, and vice versa. And that’s pretty much how value and momentum have behaved in real life. The correlation between the MSCI USA Value Index and the MSCI USA Momentum Index has been a negative 0.25 percent since 1975.

Value and momentum’s negative correlation makes a combination of the two an ideal recipe for diversification. A 50-50 blend of the two indices returned 13.2 percent annually from January 1975 to June 2016 (including dividends), with a standard deviation of 15.4 percent. By contrast, the MSCI USA Index – a broad market index – returned just 11.7 percent annually over the same period, with only a slightly lower standard deviation of 15 percent. (Standard deviation reflects the performance volatility of an investment; a lower standard deviation indicates a less bumpy ride.)

Perfect Pair
The negative correlation between value and momentum has allowed a combination of the two to beat the broader market with nearly the same volatility from January 1975 to June 2016.
SOURCES: MSCI, Bloomberg
Note: Standard deviation reflects the performance volatility of an investment; a lower standard deviation indicates a less bumpy ride.

Part of the magic behind the combination of value and momentum is that at least one of them has managed to beat the broad market – as represented by the MSCI USA Index – an astonishing 90 percent of the time over rolling 12-month periods since 1975. And value and momentum have simultaneously beaten the broad market 19 percent of the time over those same periods.   

The other part, of course, stems from the way value and momentum take turns outdoing one another. Momentum has dominated value over the last several years – the Momentum Index outpaced the Value Index by 4.3 percent annually from 2010 to 2015. Now value is punching back – the Value Index has beaten the Momentum Index by 1.9 percent this year through Thursday.   

Value’s recent resurgence doesn’t mean, of course, that investors should dump momentum and go hog-wild on value. But now may be an opportune time for investors to examine their mutual funds and ETFs to see whether those funds rely too heavily – or even exclusively – on momentum. 

It’s also worth noting that a stock fund needn’t have “momentum” slapped across its name for momentum to be in play. Market-capitalization weighted funds – such as S&P 500 index funds, for example – are, in part, momentum vehicles. By definition, their market-cap weighting requires them to buy more of the stocks that have advanced and to sell some of the stocks that have declined.

This helps explain why value has trailed the broader market in recent years -- and why those days are probably over for the time being. So move over momentum. Value's back.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Nir Kaissar in Washington at nkaissar1@bloomberg.net

To contact the editor responsible for this story:
Timothy L. O'Brien at tobrien46@bloomberg.net