Thursday, August 30, 2007

Technical Thursdays: Style Investing – Momentum versus Contrarian

"Bernanke says nothing new, stocks soar!"

That easily could have been the headline explaining yesterday’s lemming-like, momentum driven stampede back into stocks. Which raises the issue just what is the investment style of most professional investors?

I don’t know if anyone has the data on this, but the past two days of market action – plunge then surge – sure looks like most professional investors, particularly the very short term hedge fund variety, are little more than momentum players. And while this may have always been the case, perhaps it has gone to another level: Momentum players on steroids. (Note to Barry Bonds: I see a hedge fund manager position in your future.)

Now, it is a fact that correlations between, among, and within asset classes are at their highest levels ever. And knowing this fact is helpful in planning and executing exploitative investment strategies and tactics (which is what I and other good contrarian investors try to do). But what struck me about Tuesday’s plunge and Wednesday’s surge is how stocks ended each day at their respective lows and highs (see chart above).

And this leads me to speculate that the vast majority of hot money traders (at least those who are active right now) must not only be momentum oriented speculators (maybe gamblers is a more apt word to use), but that have become so desperate for relative performance that they cannot afford to risk missing any move that has appears to pick up steam. If this is the case, when the rest of the gang returns from East Hampton volatility should rise even further to levels not seen in nearly a decade.

Investment Strategy Implications

For true investors, the noise factor from this whipsaw action is deafening. So, my advice is to put on your Bose noise cancellation headphones (earmuffs, if you prefer), tune out the noise, and pick your spots where prices get out of alignment with value. The momentum lemmings may be desperate for relative performance (their third yacht depends on it) and that presents opportunities for the rest of us.

In times like these, it takes conviction and commitment both by an investor and his/her clients to be a contrarian. But isn't that what buy low, sell high is all about?

Note: To view a larger version of the chart, simply click on the image.

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