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Momentum investing

Financial prophecies have lives of their own and, much of the time, they are dead wrong. Read the financial press and with every runup of price of some asset, there are stories saying that zooming prices of gold, potash, various hot stocks and even some junk bonds are only the beginning. With a little numerology, authors say that the best is yet to come. Almost always, these top of the market extrapolation stories are wrong. Those who buy into the tales wind up losers. The fables, for that is what they are, rely on a numbers game in every case.

Authors James K. Glassman and Kevin A. Hassett published Dow 36,000: The New Strategy for Profiting from the Coming Rise in the Stock Market in 1999. Their concept seemed to be validated by the ascent of the Dow Jones Industrial Average to a record high of 11,750 in January, 2000.

The Dow index had been driven upward by the general enthusiasm of the stock market. The Iron Curtain had fallen and Russia had abandoned communism 11 years earlier. The dot com bubble was opening new territory for stocks of companies that had no earnings, no revenue and often no business plans. Many investors bought into the idea that the Dow and other American stock markets were on an unstoppable trajectory upward. And then came the market crash following the September 11, 2001 tragedy of the twin towers, the bursting of the dot com bubble, the 2008-2009 collapse of the American housing market, the downfall of many banks that had been part of the housing bubble and associated risks, and, currently, the Eurocrisis. One can’t blame Glassman and Hassett for failure to know about 9/11 and the peril now crippling Europe, but one can challenge their math.

Momentum theory

In bubbleology, the rule is to extrapolate. If the Dow had gained eight per cent per year (not far off its historic trend of gaining about five per cent per year plus three per cent or so for inflation), it would have risen to 25,265 between 2000 and 2010.

So much for extrapolation. Today, the Dow Jones Industrial Average is at about 12,400.

Investing on momentum or on a momentum theory leads to bloodbaths. Consider that the internet bubble, which burst ten years ago, generated losses of 80 per cent to 100 per cent and cost investors about US$4.8 trillion between the 2000 peak and the end of 2001.

It was not just the new technology of the internet that drove up stock prices before they collapsed. Entire stock markets can be skewed by sector enthusiasms. The best (or worst) example is what happened on the London stock exchange 319 years ago.

With the opening of new worlds in the Americas and the South Seas, merchant companies were encouraging folks with some cash in their silk stockings to take a piece of the action. An investor in 1693 would have lost 70 per cent within three years. After the South Seas bubble burst, our immortal investor would have had to wait to 1961 to see a nominal recovery of sums invested. The investor’s return would have been a crummy 1.44 per cent per year for 268 years if dividends had been reinvested. But take off inflation for that time and the rate of return shrivels below zero to minus 0.082 per cent for the period.

Had our immortal investor figured that he would take a crack at getting money lost in 1693 back by investing in the South Seas bubble at its peak in 1720, he or she would have lost 0.58 per cent for the period. That would have enlarged the loss based on the 1693 market entry 7.25 times.

Today’s market

Let’s look at two hot sectors in today’s market. In 2011, falling interest rates, especially long rates, drove the returns of Canadian mutual funds specializing in bonds with maturities of 10 to 30 years to 16.35 per cent for the year. That was more than twice the 10-year average annual compound return of long bond funds.

In the U.S., long Treasuries had their best performance since 1995. Treasuries with 10 or more years to maturity rose 25.6 per cent, pushed by the sovereign debt crisis in Europe and flight of money to U.S. government debt.

These one-year numbers are not likely to persist unless there are crises that drive investors to accept even lower running yields. A collapse of the Euro would probably do it, though the odds are that the wizards of European finance will avert that outcome. A worsening recession or perhaps a North American deflation would also boost bonds, though neither scenario seems likely.

Another hot sector in 2011 was Real Estate Investment Trusts. REITS are companies that build and lease shopping centres, office buildings, apartment buildings and long term care homes for the ill and the elderly. One very well run exchange traded fund, the BMO Equal Weight REITs Index ETF (ZRE) gained about 60 per cent in price last year and has a current yield of 5.2 per cent.

REITs generally had a good year in 2011 but a repeat of their 2011 performance is unlikely. They are all heavily mortgaged and, as interest rates rise, their profits, which are the difference between the rents they charge and the mortgage interest they pay, are likely to decline.

Though the press is filled with lavish praise for REITs, institutional funds are quietly leaving the sector. The professionals know it is time to leave and are selling to newbies. The moral of the tale? Be a leader rather than a follower.

Betting on momentum is like driving while looking in the rear view mirror. It is a perilous thing to do. And investing in a bubble is committing financial suicide, with the distinction that the weapon is a pencil.

Bubble avoidance is tough. Investors in bonds, commodities, stocks and even collectibles tend to think that prices that rise will continue to rise. Investors find rising prices attractive and are inclined to plunge with their own money. Ironically, if we are talking about tomatoes, the opposite happens. The difference, of course, is that investments are for resale while salad fixings are for consumption.

All that leads to a simple rule of thumb. Think of investments as a crop you plant.

The more you pay, the lower the return as a fraction of the price paid. For stocks that have dividends, higher prices mean lower yields (the ratio of dividend to stock price). For bonds, compare the interest received and the eventual return of principal with the cost of the bond. Looked at that way, the investments are less speculative and more rational. And if the news for any asset is that the professionals are leaving and selling out to retail investors, look for something else.

Warren Buffett had it right when he said, “If you’re in a room and you don’t know who the sucker is, it’s you.” I can say no more. †

About the author

Columnist

Andrew Allentuck’s book, “Cherished Fortune: Build Your Portfolio Like Your Own Business,” written with co-author Benoit Poliquin, was recently published by Dundurn Press.

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