Value or Momentum?
By S.P. Brown

Value or momentum investing, which is the better strategy? It's no secret that momentum investing has ruled the roost over the past two years. In fact, momentum investing, as defined by trend following in high-beta, high-growth stocks, was the primary catalyst for the Nasdaq Composite Index (COMPX) making its stratospheric run from 1,700 in late 1998 to 5,000 in early 2000.

Over the past two months, though, the times have been a- changin'. The trend has been broken and the scourge of momentum investing, volatility, has become the norm. What's more, many analysts are predicting the market to remain flat and volatile through the summer. If that's the case, momentum investing becomes a money-losing proposition.

So, does that mean that traders and investors should jettison momentum and adopt value? Maybe.

A momentum strategy works best when markets exhibit a stable trend, which means it works poorly when markets are unstable. The reason being, momentum investing is basically a buy-high, sell-low strategy. As stock prices rise, more stock is purchased. Then, if prices fall, more stock is sold, which is why an established trend is so important to successful momentum investing.

A value-oriented strategy, on the other hand, thrives in an atmosphere where stocks periodically become over and undervalued, which is what happens in volatile markets. Value investors buy on dips and sell into rallies.

Moreover, when market conditions change rapidly, the relative amount of money being managed using various strategies can affect market behavior. For example, back in October 1987, roughly $70 billion was being managed by investors who were employing a momentum investing strategy.

As many experienced investors remember, stock prices fell hard when market sentiment changed because many investors and money managers continued to sell as prices fell, which only exacerbated the sell-off.

Of course, for any sale to take place, there must be a buyer. The investors who usually take the other side to momentum trades are value investors, since they tend to buy stocks when prices fall.

However, back in October 1987, only about $20 billion was being deployed by investors employing a value-oriented strategy, which meant there was more stock for sale because of the selling of the momentum investors then there was buying from the value investors.

This "strategic imbalance" in the market contributed mightily to the swiftness of the decline in stock prices. Furthermore, due to execution problems encountered by money managers who were using insured strategies, the popularity of momentum investing dwindled and value-oriented investing gained in popularity.

A more contemporary example of how disastrous it can be when the trend finally breaks was reported recently in the Wall Street Journal. It seams the legendary trader Stanley Druckenmiller lost a boat-load of money recently when the trend broke in the Internet-security firm VeriSign (VRSN). Druckenmiller bought at $50 a share last year and continued buying up to $258 late February.

By early March, Druckenmiller had doubled his bet on VeriSign to $600 million at $240 per share.

Then, the inevitable happened. The Nasdaq crumbled and VeriSign tanked to $135 a share by early April. It then fell further to $96 before rallying to $118, where it now stands.

Druckenmiller's unfortunate timing with VeriSign was one reason his boss, George Soros, wasn't terribly disappointed when he threw in the towel last month.

Lest value investors get too cocky, that strategy also has been known to destroy careers. A few weeks ago, long-time value investor Julian Robertson closed shop after prematurely making huge leveraged bets on permanent value plays US Air (U), Unisys (UIS) and General Motors (GM).

The truth is, the dominance of one strategy will tend to produce the very market conditions which is least favorable to that strategy. If the momentum investing dominates, markets tend to become very volatile because as the price of stocks rise, the strategy requires investors to increase their buying of stocks. And as the price of stocks decline, investors are required to increase their selling. The market can often experience a big push in either direction once a trend is established.

Similarly, if value investing dominates, markets tend to become more stable, since a decrease in the price of stocks will induce more buying; whereas, an increase in the price of stocks will induce more selling. As a greater amount of money is managed via value investing strategies, more buyers develop as stock prices drop lower, which ultimately restores the balance needed to stop the slide.

From the foregoing, it should be clear that no single stock strategy is superior at all times. If the majority of invested dollars are managed with value strategies, the markets will become more stable, since these strategies require the selling of stocks whose prices rises and the buying of stocks whose prices falls.

In that type of market, those who follow a momentum strategy will do better because a momentum strategy will enhance performance when the market has a definite trend that dominates volatility.

This offers a new twist on contrary investing: Employ the opposite strategy from that of the crowd. When value-oriented strategies are very popular, it may be best to shift to a momentum strategy because the dominance of the value strategy will produce the type of stable environment which is best exploited by trend-following strategies.

On the other hand, when momentum-bases strategies are very popular, it may be best to shift to a value strategy because of the dominance of the momentum strategies will produce the volatile market environment which is best exploited by value strategies.

Obviously, the secret to making money is knowing which of the two market sentiments dominates. As of today, it appears the market is operating in a trendless, value-oriented mood. But that's not to say we can't break into a trend-oriented market soon.

Discerning what the future investing environment will be is tough business, which is why making money consistently in the stock market is so darn hard. It's easy to see where we've been, but where we're going is what's most important.