The equity markets may be on the brink of a seismic change. Momentum stocks have been a major factor propelling the bull market to record highs during the past decade. However, since Aug. 27, 2019 they have plunged by 14%, their worst two-week return since 2009 and also worse than 99% of their historical returns since 1980, according to a detailed report from Goldman Sachs.
"Sharp Momentum drawdowns similar to the one that has taken place in the last two weeks usually mark the end of the Momentum rallies rather than tactical buying opportunities," Goldman observes in their current report, "US Macroscope: Five questions and answers on the Momentum reversal."
- Stocks that had been laggards are now outperforming momentum stocks.
- Investors are unwinding positions in the most crowded sectors.
- The long rally in momentum stocks may be over.
- Value stocks may continue to underperform growth stocks.
- Economic growth is more likely to rise than fall in the near term.
Below is a closer look at the Goldman's 5 key takeaways on this trend.
While the drop in momentum stocks over the past two weeks was sharp, it simply unwound a robust rally that propelled these stocks upward by 17% for the month through Aug. 27. During the past 40 years, a rally of that magnitude previously was seen only in the late 1990s and the late 2000s.
"The reversal in Momentum captured sharp rotations in other equity factors and sectors that had become increasingly correlated with each other," the report notes. Growth stocks and low volatility stocks also fell, while small caps and value stocks outperformed the broader market. Investors rotated away from bond proxies, such as utilities, and secular growth stocks, such as software and information technology services, shifting their portfolios towards cyclical stocks, such as consumer durables, that generally had lagged the market over the prior 12 months.
"Rising portfolio concentration, falling position turnover, and increased crowding have accelerated in recent quarters and increased the risk of a positioning-driven unwind. The rise in crowding helped drive the outperformance of the most popular stocks," Goldman says.
Meanwhile, strength in selected U.S. economic data such as services, and renewed hopes for a U.S.-China trade agreement, have made investors less worried about a possible recession. "These catalysts released the potential energy created by investor crowding, moving 10-year US Treasury yields from 1.45% to 1.75% and driving the equity Momentum unwind," the report indicates.
End of Momentum Rally?
"Momentum has traded flat during the months following similar sharp drawdowns," based on history from 1980 onwards, Goldman says. One reason is that the universe of momentum stocks is constantly shifting. On average, Goldman's basket of momentum stocks has 25% turnover each month, but this is likely to be much higher during the next rebalancing as a result of the recent drawdown.
"Momentum typically performs best during extended periods of macroeconomic and market consistency," the report notes. During the past 12 months, indications of slowing economic growth turned defensive stocks into momentum plays. Now investors are pivoting toward cyclicals, based on upbeat economic news.
Rotation From Growth to Value?
The lengthy underperformance of value stocks compared to growth stocks has produced the widest valuation gap between the most and least expensive S&P 500 stocks since 2000. However, history indicates that value stocks tend to outperform during periods of either very high or very low economic growth. Unless the economy either rebounds sharply or slips into recession, both growth stocks and "quality" stocks that can endure a weak economy should continue to be favored by investors, says Goldman.
'Modest Economic Growth Reacceleration'
Goldman forecasts real GDP growth in the U.S. of 1.9% in the second half of 2019, rising to 2.4% in the first half of 2020. However, the firm warns that economic uncertainty and recession risk remain high, and that a shift in investor sentiment about trade back towards pessimism remains a danger for the markets.
"Looking forward, for Momentum to resume its outperformance, investors will need to either return quickly to the mindset of economic deceleration and recession risk, or wait until Momentum builds again in a form appropriate for an improved economic environment," Goldman advises.
More specifically, they say, "We recommend investors avoid the most highly-valued US stocks." Also, they add, "We believe investors should continue to favor companies with strong idiosyncratic growth prospects and “quality” attributes like high returns on capital rather than focusing purely on the stocks trading at the lowest valuations."