The 2 Most Powerful Forces in Markets

By Charlie Bilello

29 Mar 2021

Momentum and Mean Reversion.

The two most powerful forces in markets.

Momentum dictates that what has done the best in the past will continue to do the best and Mean Reversion just the opposite – where what is done the worst will eventually do the best, reverting back to its mean.

That both can be true is one of the great paradoxes in investing.

After the pandemic began last year, we saw one of the most epic momentum runs in history. Many of the leading stocks and sectors (particularly in technology) heading into the pandemic would see their trends accelerate to the upside when the shutdowns began in last April.

This resulted in significant outperformance among leading stocks, with the highest momentum names showing the most outperformance.

You can see this play out in the chart below, which illustrates the returns of 3 ETFs from the start of 2020 through February 12 of this year. The concentrated momentum ETF ($QMOM, 50 positions) was up 107% versus 43% for the diversified momentum ETF ($MTUM, 125 positions) and 24% for the S&P 500 ($SPY, 500 positions).

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Then, without any notice, the trends stopped. Since February 12, we’ve witnessed one of the sharpest momentum reversals ever, with the S&P 500 gaining 1% while diversified momentum ($MTUM) declined 12% and concentrated momentum fell 28% ($QMOM).

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On a relative basis, this reversal has wiped out most of the gains since the start of 2020 for diversified momentum ($MTUM vs. $SPY) and 8 months of gains for concentrated momentum ($QMOM vs. $SPY).

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While momentum has been getting crushed, these have been the best of times for mean reversion, where previously beaten up stocks and sectors have been outperforming by a wide margin.

The 25 stocks in the S&P 500 with the lowest returns last year are all positive to start the year, with a medium return of +32%.

And the worst performing sectors from last year are outperforming this year, led by Energy (+33%) and Financials (+17%).

On the flip side, the best performing stocks from last year are underperforming with a median return of -3% to start the year.

And Technology stocks ($XLK) are underperforming the broad market this year after leading all sectors in 2019 and 2020…

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This reversion to the mean is finally starting to benefit value strategies, which had been underperforming for over a decade prior to its relative strength low last September. Since then we’ve see one popular value ETF ($VLUE) nearly triple the performance of the broad market.

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The combination of momentum’s downturn and value’s upturn has resulted in the most significant relative correction of momentum versus value (-26%) that we’ve seen in a long time, with most of the underperformance coming in just the last month and a half…

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The lessons here are many:
1. Momentum and Mean Reversion are two of the most powerful forces in markets. Why? Because human beings and their emotions are involved.
2. At times those emotions cause momentum as we chase the recent past (on the expectation that it will continue into the future) and performance persists. And at other times our fear or greed pushes assets to extremes, stretching the rubber band until it snaps back in dramatic fashion and mean reversion takes hold.
3. All factors (momentum, value, quality, low volatility, etc.) are cyclical with periods of outperformance and underperformance. No one knows how long these periods will last and they can last much longer than you think (see value’s underperformance from 2006-2020).
4. There is no free lunch. You cannot have the potential for upside and long-term outperformance without suffering periods of downside along the way. New momentum investors are learning this lesson in spades. Value investors, whoever is left among them, have learned this lesson for over a decade.
5. In the past year we’ve seen both forces on full display, from one of the most extreme momentum runs in history to one of the most extreme mean reversions.
6. Given all that has occurred in the past year (worldwide pandemic, shutdowns, reopenings, vaccines, the road to herd immunity, etc.), perhaps these extremes are not that surprising. And as investors we should be prepared for many more surprises ahead.

Related Post: The Great Reversal in Secular Trends


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