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Why Has Momentum Persisted?

Shannon Zimmerman

Shannon Zimmerman: For Morningstar, I am Shannon Zimmerman.

I am here today with Doug Ramsey from Leuthold Weeden Capital Management.

Doug, thank you so much for being with us today.

Doug Ramsey: Thanks for having me.

Zimmerman: Doug is here with us to have a panel discussion with a couple other folks about price momentum and earnings momentum as well, which is among the strategies that Leuthold uses in a number of its funds. Doug is a portfolio manager on the Core Investment Portfolio, Asset Allocation, and then also Leuthold's Global Fund.

Doug can you talk a little bit about Leuthold's overall approach to investing and then maybe discuss how price momentum or earnings growth momentum slots into that approach?

Ramsey: We consider ourselves to be flexible investors. Our primary funds are all tactical asset allocation funds, where we've got the latitude to shift net equity exposure around fairly significantly. 30% would be our normal minimum, although we've even undercut that number in the past, near the bubble highs of '99 and 2000, and then we'll take it to 70% at the maximum. So, that's an enormous amount of flexibility relative to your average balanced fund. And then where we use momentum is in group and security selection, within the equity pieces of those portfolios.

Zimmerman: Is it primarily price momentum or is there an earnings model as well?

Ramsey: There is an earnings model as well in terms of the overall impact on the portfolio. So, I would say, the price momentum is a bigger driver.

Zimmerman: You and I have talked about before, and we'll talk about this on the panel that's upcoming, but you've done some research into comparing those two approaches. And there's a pretty close correlation between the effectiveness of price momentum and earnings momentum…

Ramsey: ... Generally, I tend to think of earnings momentum, estimate revisions, and price momentum as belonging to the broader group of success-based strategies. In other words, you would expect the trend to persist and just comparing success-based to mean-reverting, where low is good and you are expecting to come back up to some sort of mean. So, I think in terms of how those types of factors, if you will, behave over a cycle, they are very similar.

Zimmerman: I know you have a background as well in behavioral finance. Let's talk a little bit about that as among the reasons why momentum has persisted.

You look at the decades-long track record, just empirical observation, it persists, and yet it's such a simple strategy that anyone could emulate. Why hasn't it been arbitraged away?

Ramsey: It's very difficult, I think, emotionally to execute, and there is a human need to want to be able to economically rationalize something. And I almost think there is some condescension towards the idea that just following a strong trend can somehow outperform my value analysis or my fundamental analysis.

Zimmerman: Stock investment ought to be hard and complicated, right?

Ramsey: Exactly. So, I think that's a big piece of it.

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Zimmerman: So, fundamental-based, bottom-up stock-picking investors, which many folks are, and you have fundamental screens in your models as well. Is there a way in which momentum--which is, of course, considered a technical strategy--actually anticipates or affirms fundamental health?

Ramsey: I certainly believe that. In fact, let's go back 12, 13 years, when traditional low P/E value investing was having a very difficult time. The end of the bubble period from '97 really to '99, a popular strategy became value with a catalyst, rather than just buying a list of low P/E or low price-to-book stocks.

I think a lot of the quants decided that, look we can use emerging price momentum as the surrogate for fundamental analysis. In other words, savvy investors will do the legwork for you and start to bid that into the stock price.

Zimmerman: Almost a spin-off of efficient markets theory?

Ramsey: ...I don't know if you're going to get me to say a whole positive necessarily about that--but yeah, to some extent, I mean the market does discount things and looks ahead, and just following that early momentum, when combined with value, unless you're at the very forefront, getting the first call, so to speak, from Wall Street analysts and doing the absolute best on the street research, momentum becomes a very good surrogate, especially at the industry-group level.

That's where I would really distinguish what we do from a lot of traditional quants is that we're very heavy into the industry analysis, and we have found that most of the returns can be harvested through an industry rotation strategy and that, of course, it can be captured at the stock level as well, but most of the excess returns are derived from concentrations in industry…

Zimmerman: ... So, you drill down below the level of this sector and you look into individual industries and then check into the price momentum of that industry group?

Ramsey: Right.

Zimmerman: ... when you're constructing the portfolios. So, Leuthold has many, many factors that it considers in this proprietary model. How does price momentum, how is it weighted, and how does it work? There are some market environments in which price momentum works quite well.

Ramsey: Right.

Zimmerman: And some in which it doesn't. 2008 was really tough time, into 2009 for price momentum in particular, because it has a lot of inflection point venerability.

Is there way in which some of the fundamental factors might work across purposes or odds with price momentum and what have you found in your research?

Ramsey: The value factors and other contrarian factors within our domestic group model, we use insider buying and selling. That very often will have a counter pattern to what momentum does. Something that I think helps us avoid--and I think what you're getting at here is what we would call inflection point risk--is that, the typical quantitative approach with any sort of factor, including momentum, would be to quintile or decile it, which assumes that you always have a fairly constant distribution. Whereas we have some elements within our rankings that are just absolute scores. In other words, when you have a situation, let's think, late '08, early '09, there were some outperformers among groups, obviously, among health care, consumer staples, and utilities. But in terms of absolute price action everything was down. So, our models by not imposing a quintile or decile system recognize that. So that, at least in an element of our scores, they really had all the same scores, so momentum began to drop out at a good time for it to drop out, because the ensuing year off the March 9 bottom was just one of the worst we have ever seen for just conventional price momentum, 12-month price momentum.

Zimmerman: That's one of the risk measures and the risk controls that you have at the core portfolio in particular, and the other offerings where you are a manager as well at Leuthold?

Ramsey: Correct.

Zimmerman: Just one last question. One of the most thoroughly documented in academic literature around momentum, and there's a quite a library of it at this stage, points to 12-month price momentum. You define your investible universe based on the stocks that have performed best over the preceding 12 months, but you don't consider that 12-month when you rank them, as a way of, I guess, mitigating the inflection point venerability.

Ramsey: Right.

Zimmerman: But at Leuthold, there is a contrarian factor in the model that you use. And so that's not your approach at your shop. Could you talk a little bit about why that's the case?

Ramsey: About the short-term reversal effect?

Zimmerman: Exactly.

Ramsey: Okay. We have found, and I don't think this is necessarily a shop secret, from a behavioral finance perspective, the reason that intermediate-term momentum works, and when I say intermediate term, it would be about that 12-month length, six to 12 months, is an under-reaction effect. In other words, fundamentals are improving and investors just don't believe it or they think, hey, we're too late, we've missed it. So specifically we look at price one month ago versus price 12 months ago, so it's really 11-month momentum, one month ago.

But to look back over the most recent month, the one-month momentum effect is often mean-reverting, and the way you could put behavioral finance wrapper around that is say that, look, in the very short term, investors are myopic and overreact, so there is an overreaction effect in the very short term and an under-reaction effect when you get beyond that month.

So our measure, reversal-adjusted momentum is what we call it, and it's pretty effective and it helped us significantly. We run some short money as well in the form of a fund called the Grizzly Fund...

Some of those financial stocks, if you remember, we had some tremendous short-term rallies. So you had financial stocks that had horrific intermediate-term momentum, that had these one-month bounces, and we were able to reload onto some of those, not to point the finger at us as causing the financial stock meltdown. ...And again, I think there is a very good behavioral rationale as to why that is sort of a behavioral construct.

Zimmerman: Back to the short-term reversal effect, at Leuthold, investor sentiment is a contrarian indicator right? The higher sentiment is, the more positive sentiment is, the worse you guys feel about the market.

Ramsey: Correct, and just on a broader market note to that extent, as we speak right now, the market's down about 5% from its late April high. I am impressed with the fact that despite how shallow that correction has been, we've seen a big improvement in those sentiment numbers. I mean a lot of fear building up on the options market, all the investor surveys that we monitor have really come down from highs that we're seeing …

Zimmerman: And Leuthold is dialing down its equity exposure somewhat.

Ramsey: Somewhat. We had been as high as 64%-65% earlier in the year--again with 70% being the maximum aggressive. Right now we're 60%. Our thinking is that the bull market is not over. There will be higher highs yet in the fall and may be into next year and then we think that might be about it, so we've been talking about the final high of 1500 to 1550.

Zimmerman: Over what time period?

Ramsey: Over the next, let's say nine to 12 months.

Zimmerman: I hope you're right.

Ramsey: All right. Thank you very much.

Zimmerman: Doug Ramsey, thank you very much for being with us today. Let's go to our panel discussion.

Ramsey: Thanks, Shannon.