Momentum & the Gambler’s Fallacy

Momentum has been the big surprise for investors this year. Markets may seem largely directionless, but many big stocks have nevertheless carried on rising. Large cap global businesses have become more and more expensive, as investors climb aboard this rising trend. Across Europe, the valuation gulf between global and domestic businesses is at a multi-year extreme. Those waiting for setbacks, or who simply have portfolios focused on value or small cap, are struggling to understand this pattern. Why are these trends so persistent, and what makes this particularly challenging for investment professionals?

Psychological failings are often seen as only a problem for private investors. Professionals think that biases can be conquered just by thinking harder. But one key behavioural bias actually tends to be worse for smarter investors. They often dismiss momentum as some sort of naive herding behaviour and see wisdom in patiently waiting for reversals. Yet, expecting an averaging out of performance or rotation may simply represent a misunderstanding of statistics – at least in terms of the timescale on which this is likely to happen. Few have the years of patience that it takes to reverse a trend. And, there are good underlying reasons for current momentum, and why investors should hold on to this year’s best performing shares.

Businesses with strong balance sheets and good strategic positions are winning this year. For them, financing is easy, with open credit markets. In contrast, weaker businesses are finding it hard to secure the funds to recover or restructure. Instead of the weak getting fixed with new management and financing, banks seem unwilling to risk putting in good money after bad. Bank deleveraging is accelerating; securing support for businesses that have weaker balance sheets or are losing market share is difficult and expensive. Banks know that improving loan book quality means cutting back on lending to weaker businesses.

Businesses with a weak strategic position are not only now seeing poor gross profit margins, but are also paying much more for their finance. The money needed to allow restructuring or acquisitions is simply not available. Weak businesses are stuck with their bad divisions and uncompetitive cost bases. So, investing in weak companies for recovery is now much riskier.

Certainly, global growth is fragile. Buying growth does not just mean defensive sectors like tobacco, food and pharmaceuticals. Many industrial businesses that are often dismissed as cyclical have these inherent growth characteristics; new products and self-help. There are winning strategies in most sectors. Typically, these are global businesses, benefiting from US economic recovery, and which should benefit from stimulation in Europe.

Many major European stocks also offer good dividend yields. Indeed, as investors reach for income, it seems that blue chip growth shares can offer better yields than sovereign debt, with similar credit quality. If Europe does print money, it is likely that much of this cash will look for prime assets, whether property or large capitalisation global equities. These underlying trends could take blue chip stocks in Europe much higher still.

If this environment persists, this year’s winners could be the best pick for 2013, too. Momentum of large cap, “quality” stocks is simply a continued re-rating of credit quality. We may be only half way through this trend. Fund managers need to set aside their inclination to sell out of stocks that have re-rated significantly following outperformance, and instead recognise that much higher valuations could be possible. Betting against momentum based on such strong underlying factors may not be wise; a misplaced bet on misunderstood statistics. Investors need to accept that trends can run much longer than expected. For smart investors, it may seem irrational to bet on the strong getting stronger. But, times are unusual and credit now matters for shares.