What Drives Market Prices? The Valuation vs. Momentum Dichotomy

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Professional investors attempt to find a cognizant understanding of why stocks move, whether they develop this through years of a professional career, or rely on the findings of trusted quantitative or fundamental analysis to help hone their skills.  Either way, having the resources to identify what ultimately moves market prices over the long term can be a valuable asset to help better understand the stock market and leverage that information for the benefit of you and your clients.

We, The Applied Finance Group, would like to focus on the relationship that we have observed between valuation and momentum over the last decade.  Typically, long-term valuation is the main driver of stock performance, as companies that are trading at a discount to their intrinsic values tend to migrate up to a higher valuation over time.  (Inversely, companies trading above their intrinsic values will migrate down.)  If we were to attempt to quantify this, it appears that aggregate stock movement can be explained by long-term valuation adjustments roughly 75% of the time.  The remaining 25% of markets are best identified as momentum markets, which simply imply that a short-term event has created an environment that makes investors less concerned with long-term value but more focused on short-term issues.  This shift in investor preference has often led to a flight to quality or “safe” stocks, and in these markets we can witness outperformance from a momentum-based strategy, which can be based on momentum of price changes or earnings forecasts.

 
Valuation vs. Momentum: 1998 - 2009
 
To dig a little deeper into this, we will focus on the S&P 500, using data from 9/25/98 - 7/31/09.  The graph below highlights the performance of the S&P 500 through this period, with the blue shading included to represent the periods of time where long-term valuation drove market prices.  Below the chart, we have included a brief explanation of the four momentum markets that we have identified on the chart.

  
Source: The Applied Finance Group

(1) June 1999 - February 2000: From 1990 forward, corporate earnings were growing at a fairly healthy pace, but by mid-1999, investors became more defensive due to the economic crisis in the Pacific Rim, and began to feel uncomfortable with future corporate growth rates and the stability of the global capital markets. During this shift, investors flocked to mega-cap S&P 500 companies and fled from the stocks that they deemed riskier. By February 2000, however, the markets began to again focus on future growth and valuation. (Note: since the S&P 500 is market-cap weighted, this run on mega-cap S&P 500 stocks caused the index to rise through this momentum market. Once valuation started to take hold, investors began to fairly price mega-cap stocks downward.)

(2) September 2001: The stock market was severely impacted by the attacks on the World Trade Center, where the S&P 500 declined by nearly 12% over a ten day period leading up to the end of September.

(3) May 2002 - October 2002: The internet bubble had burst, and investor confidence was further shaken due to multiple accounting scandals. We again saw a flight to short-term quality that led long-term valuation to be overlooked.

(4) June 2007 - November 2008: As we saw in early recessionary periods, this momentum market was highlighted by a loss of investor confidence which again created a flight to quality companies with stable profitability. In the next couple of weeks, we will take a look at this period in greater detail in an upcoming article.

Analyzing Valuation and Momentum Markets Independently - Insight From Changing Markets

Due to its significant overall outperformance, we believe utilizing a trust-worthy valuation metric is an important starting point in stock screening. With that said, a simple valuation-only strategy can hinder the performance of your portfolio when momentum-driven markets are at play. Let’s first explore the valuation-only performance of the S&P 500 from September 1998 to July 2009 by deciles, with a further breakdown of each individual valuation and momentum market. (Note that the returns on this chart represent the cumulative performance of each decile, assuming monthly turnover.)

Percent to Target - Current

Decile Performance in Valuation and Momentum Markets (9/1998 - 6/2009)

 
Source: The Applied Finance Group

To the left of this chart, we can observe the significant outperformance of the top five deciles over the bottom five deciles (based on valuation) for the duration of the entire period, but we can also see that this outperformance was mostly derived from the valuation periods shaded in light blue. Notice in these valuation-driven periods the increasing performance as we move towards higher Percent to Target deciles; in the momentum markets, we can see that this relationship is either flat or inverted.

Ideally, shifting from a value portfolio to a momentum portfolio at the right time could help limit your risk of underperformance in momentum markets, but as with any market timing strategy, this can be very difficult to put into practice. A more sound approach would be to include a momentum-based metric in addition to a valuation metric while screening for portfolio ideas. While positioning a portfolio to benefit from the overall outperformance generated from valuation screening, the momentum spin will help position the portfolio to significantly improve performance in momentum markets.

There are a number of momentum variables from which to choose, and for the sake of performance, we want to choose one that also works particularly well in valuation markets. The top half of price momentum underperformed the bottom half of price momentum by nearly 150 basis points in the S&P 500 from 1998 to 2009, so we would discourage using a price momentum-based variable in your portfolio screening. In this article, we will use EM Momentum; positive EM Momentum firms outperformed negative EM Momentum firms in the S&P 500 by 125 basis points from 1998 to 2009. The chart below highlights a buy & sell list created by the top half and bottom half of our valuation metric, along with the performance of a secondary strategy including the halves of EM Momentum overlaid on our valuation criteria.

Percent to Target - Current & Economic Margin Momentum

Strategy Performance in Valuation and Momentum Markets (9/1998 - 6/2009)

Source: The Applied Finance Group

We can observe that, over the long term, performance is significantly improved with the momentum overlay. In valuation periods, the overlay slightly lowered the outperformance when compared to the valuation-only strategy, but in momentum years, it significantly improved the performance. The table below highlights these relationships during each valuation and momentum market that we have observed since 1998.

Percent to Target - Current & Economic Margin Momentum

Strategy Performance through Valuation & Momentum Markets (9/1998 - 6/2009)

Source: The Applied Finance Group

What does this mean for my portfolio?

Professional investors, click here to learn more about our propriatary equity valuation variables.

We believe that a valuation framework is a tremendously effective starting point for your stock selection criteria.  But because markets do not always act rationally with valuation in mind, it is important to protect your clients' assets in these periods of distress or uncertainty.  Adding a momentum-based variable to your selection criteria not only improves the overall performance based on our analysis, but also helps eliminate the underperformance for the several periods of time when valuation alone did not work as well.