The Overlooked Market Factor That Drives Gains

Editor's note: As Yankees legend Yogi Berra said, "It's tough to make predictions, especially about the future." Fortunately for investors, plenty of financial metrics can help us pick better stocks – and it's not all about valuation. As Joel Litman from our corporate affiliate Altimetry explains, economists long dismissed one of the most predictive metrics in the market today...

For more than 100 years, economists have been telling us that the market is efficient...

It just makes sense. Of course the market reflects all the information available at any moment. And with millions of investors constantly staring at all that data, the market immediately reprices whenever new information comes out.

That's what University of Chicago professors Eugene Fama and Kenneth French believed in the early 1990s... when they set out to explain why stocks move the way they do.

Fama and French started by identifying metrics that could explain a stock's moves. They referred to these metrics as "factors."

And when they introduced the idea of "factor analysis" in 1992, they believed three specific factors could explain 90% of variation in returns.

Today, I'll examine those three factors. Then, I'll show you another crucial factor – one that Fama and French overlooked – that has proved its staying power time and again...

What Goes Up... Keeps Going Up

According to Fama and French, the three key factors in stock analysis were:

1. How much the market as a whole moved
2. The size of the stock relative to the rest of the market
3. The stock's price relative to its book value 

Starting with the first factor, it shouldn't come as a surprise that individual stocks are influenced by broader market trends.

That said, as the second factor suggests, smaller stocks tend to rise more than the overall market does. Because of their size, fast growth is often easier for them to achieve than it is for larger stocks.

And the third factor tells us that companies with higher valuations at the start of a period tend to underperform those with lower valuations.

That might be a result of expectations. When a company is doing well, investors want to see more where that came from. And on the flip side, when a company is struggling, even slightly beating expectations can be enough to impress.

Those three factors cover a lot of scenarios... So it made sense for Fama and French to focus on them.

But they overlooked one critical factor...

I'm talking about momentum.

The idea behind momentum is simple: Stocks that have already risen are more likely to rise going forward.

It seems straightforward enough. But to Fama and French, it was absurd. Past performance couldn't possibly explain future performance.

That would imply that the market wasn't efficient. It would have meant that investors were ignoring obvious, easy-to-access data.

Fama flat-out refused to acknowledge momentum at all...

That is, until Cliff Asness – one of his doctoral students and teaching assistants – made him wade through the data.

Asness' 1994 doctoral dissertation was all about momentum. He found that tracking an asset's past performance could explain a lot about where it would go in the future.

As Asness likes to say, Fama was supportive of the research. But he didn't like the result.

Asness went on to combine his momentum research with Fama and French's factors. He built an entire business around them called AQR Capital Management. And he's one of the most respected voices on factor investing in the market today.

Unfortunately for Fama, momentum's influence has only gotten stronger over time.

Meanwhile, many of the simplest factors Fama and French identified, like size and valuation, have proved to be unreliable at various times.

Two factors are still consistently useful predictive tools, though...

The first is quality, or how profitable a company is.

There's simply no denying the power of strong, growing profits.

The second – you guessed it – is momentum. It remains one of the absolute best ways to determine where a stock will go next.

Combine these two factors, and you have a recipe for success.

Regards,

Joel Litman

Editor's note: Joel and his team at Altimetry have discovered a signal that traces its history back decades... based on a market pattern that has appeared before some of the market's biggest winners. It preceded the rise of Nvidia, the entire Magnificent Seven, and 448 of today's S&P 500 stocks. And now, it's firing on a new group of stocks... Reserve your seat now for Joel's presentation on August 27 to get all the details.