Academia's Most Hated Market Factor
Editor's note: When you invest in a stock, make sure the setup is right...
Joel Litman – chief investment officer of our corporate affilate Altimetry – says there's more to investing than simply analyzing a company's financials. According to him, there's an often-overlooked factor that's critical for determining where a stock is headed next.
In today's Masters Series, originally from the September 18 issue of the free Altimetry Daily Authority e-letter, Joel talks about a powerful market force that can help you calculate future stock performance...
Academia's Most Hated Market Factor
By Joel Litman, chief investment officer, Altimetry
The market is efficient.
That's the belief University of Chicago professors Eugene Fama and Kenneth French set out with in the early 1990s... when they wanted to explain why stocks move the way they do.
It just made sense. Of course the market reflects all the information available at any moment. And with all those investors staring at the numbers, the market immediately reprices for any new information that comes out.
Fama and French started with potential metrics that would fit into that framework. They referred to metrics that could explain a market's moves as "factors."
And when they introduced the idea of factor analysis in 1992, they believed three specific factors could explain 90% of a stock's move.
Today, we'll look at those three factors. Then, we'll show you another crucial factor that Fama and French overlooked – one which has proved its staying power time and again...
The original three factors worked until they didn't...
According to Fama and French, they were:
- How much the market as a whole moved...
- The size of the stock relative to the rest of the market...
- And the stock's price relative to book value.
It shouldn't come as a surprise that stocks are influenced by broader market trends.
That said, smaller stocks tend to rise more than the market does. Because of their size, it's often considered easier for them to grow faster than the rest of the market.
And companies with higher valuations at the start of a period tend to underperform those with lower valuations.
That might be due to expectations. When you're already doing well, investors want to see more of where that came from. (And on the flip side, when you're not doing so hot, even a slight beat can impress.)
Those three factors cover a lot of scenarios... So it made sense to focus on them.
But there's one critical factor that Fama and French overlooked...
I'm talking about momentum.
The idea behind momentum is simple. Stocks that have risen already are more likely to keep rising going forward.
It seems simple enough. But to Fama and French, it was absurd. Past performance couldn't possibly explain future stock performance.
That would imply the market wasn't efficient. Investors would have been 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 combined his momentum research with Fama and French's factors... building an entire business around them called AQR. (It currently boasts $121 billion in assets under management.) 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.
Meanwhile, many of his and French's most simple factors, like size and valuation, have completely stopped working as predictive tools at various times.
Two factors haven't stopped working, though...
The first is quality, or how profitable a company is.
Regular readers know there's no denying the power of strong, growing profits.
The second – you guessed it – is momentum. It remains one of the single 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 stresses you can't let this bull market pass you by. He believes many investors are suffering from the "fear of getting in," making them reluctant to put their money to work in this roller-coaster market.
But if you keep your money on the sidelines, Joel warns you could miss out on a recent breakthrough that's setting up the biggest moneymaking opportunity in the history of his firm.