While the market has staged a spectacular and unanticipated rally, looking at the broader indices can be somewhat misleading. Year-to-date, the S&P 500 Index is still down -15%, but large cap tech and healthcare indices are down 3% or less. At the same time, small caps and energy, down -26% and -43% respectively, are still stuck in a brutal bear market.
Most investors are aware that much of the differential is a function of growth versus value. However, not all the divergences can be explained by relative earnings growth or valuation. Other style factors are also driving performance. Surprisingly, momentum has done exceptionally well year-to-date.
I say surprisingly because momentum, in which investors favor stocks with the best recent performance, is normally a casualty of volatility. This is because volatility shifts the mindset from fear of missing out (FOMO) to fear of being wiped out. When stocks eventually bottom, historically it has been value that tends to be the best performer. That said, this time may be different for a variety of reasons:
1. Value is likely to struggle with an uncertain and uneven recovery.
Value typically works at a market bottom because investors anticipate a strong recovery on the back of pent up demand. Today, circumstances are very different. The recession was not caused by an aggressive Federal Reserve but by a devastating and unpredictable pathogen. Even as the pandemic subsides, unemployment may remain high and consumption muted due to lingering restrictions and changes to consumer sentiment and behavior, i.e. how long before people are comfortable heading back to restaurants, hotels or getting on an airplane?
2. Liquidity supports momentum.
While momentum typically struggles with volatility, it benefits from the policy reaction to volatility: more liquidity. As central banks have put their balance sheets at the disposal of fiscal spending, we have witnessed a surge in central bank asset holdings that has dwarfed the post-GFC response. Led by the Fed, the world’s central banks are adding trillions to their balance sheets (see Chart 1). Historically, rapid growth in liquidity has favored momentum, particularly versus more mean-reverting trading styles.
3. Momentum is less cyclical.
For investors who came of age in the 1990s, we typically associate momentum with aggressive, high-beta names. Today, momentum has a somewhat different flavor. Most momentum baskets or funds are overweight secular themes, notably technology and increasingly healthcare, specifically biotech. To the extent these segments are more insulated than other parts of the economy, and in some cases stand to benefit from longer-term structural changes, this may further favor the style.
4. Big get bigger
The trend towards momentum is also a reflection of a broader, secular theme: the big getting bigger. While the long-term impact of COVID-19 is hard to predict, it is not difficult to imagine an acceleration in trends that were already evident prior to the crisis: internet commerce, cloud computing, social media, more time and wallet-share on-line. To the extent this continues, tomorrow’s winners may look an awful lot like today’s.