Historically, momentum has been one of the most effective investment factors. Unfortunately, even it can have bad stretches. Have similar periods for the factor led to further weakness, or has momentum bounced back even stronger? 

Historically, momentum has been one of the most effective investment factors. Unfortunately, even it can have bad stretches. One way to view the effectiveness of momentum is by looking at how much the leaders (best performers) of the market have outpaced the laggards (worst performers). NDW looks at the Relative Strength Spread (RSSPREAD) as a proxy for exactly that—how much the leaders are outpacing the laggards. It takes the performance of the top quintile (best 20%) of stocks minus the bottom quintile (worst 20%) of stocks, showing the excess return of the leaders versus the laggards.  

Momentum and the RS Spread have unraveled following an extremely strong period this year. On its default chart, the index moved to its first sell signal since early March but is still up 23% YTD. Given the significant movement within the factor, just how rare is recent action? Have similar periods for the factor led to further weakness, or has momentum bounced back even stronger? 

Note: For further context on why the RS spread has pulled back recently, check out last week’s feature.

How Rare are Momentum Reversals? 

The pullback within momentum has been uncomfortable for trend following investors, but it should be noted that some periods of underperformance should always be expected. And, despite those periods, the factor has successfully identified the strongest securities over time as new leadership emerges.  

Looking at the drawdowns—defined as the maximum peak-to-trough declines—of the RS Spread can show us the largest amount by which high momentum stocks have underperformed laggards, as well as how often leaders underperform laggards by certain amounts. For example, a 5% drawdown within the RS Spread occurs once every 57 days. Said differently, we should expect high momentum stocks to underperform laggards by 5% at some point over a roughly two-month period.  

In our most recent momentum reversal, high momentum stocks underperformed laggards by as much as 18.1%. While that is admittedly uncomfortable territory for momentum followers, investors should understand that those types of movements are part of the process.  15% drawdowns for the RS Spread occur around once every 15 months, but 2023 was the last time there was such a reversal before recent action. Looking at the average year further supports this notion. At the worst point in a typical year, high momentum stocks underperform low momentum stocks by 14.2%. Despite those temporary setbacks, the annualized return of high momentum stocks outpaces low momentum stocks by 8.8% going back to 1990. Granted, not every day, month, or year is going to work out in this fashion, but the long-term success of the factor speaks for itself.  

What Happens After Momentum Reversals?  

Understanding how often these reversals occur is important, but it doesn’t give us a sense of what to expect going forward. Recent movement within momentum names has been notable for how quickly it has occurred. The RS Spread fell more than 12% in a single month, and history suggests that's usually a buying opportunity for leadership rather than the start of a breakdown.  

Since 1993, there have been 18 other instances of a decline this sharp over one month, and leadership has bounced back in the majority of those prior cases. The initial snapback tends to come quickly, with the index higher a week later nearly four times out of five, before working through a choppier patch over the following month. From there, leadership has typically found its footing again. Returns have followed a similar arc, being sharply positive over the next week, modest over the next month, then building steadily the longer you're willing to wait it out.  

Overall, the leaders beat the laggards over the next year in two thirds of similar momentum declines. Additionally, the leaders outperformed by an average of 14% over that span. Not every instance has played out this cleanly, but the broader tendency has been for leaders to reassert themselves rather than give way to a lasting shift. Periods of underperformance are when it’s most tempting to go against momentum. Historically, those periods are when the factor has worked best, highlighting the importance of sticking with your process via an unemotional, unbiased approach.