It is often said that momentum, as an investment style, adds value on average over time. And the stats say that is true. In fact, compared with other styles, such as value – the grand-daddy of all styles – it works right up until the time it doesn’t work. Here’s how quants use it.
According to Olivia Engel, the Australian who is the Boston-based CIO for active quantitative equities at State Street Global Advisors (SSGA), sentiment is an important investment theme which investors can benefit from. However, those investors need to be wary about short-term sentiment. They may well suffer in the long term.
In a recent paper, ‘How Sentiment Can Help Investors Choose Better Stocks’ SSGA says that it can use its analysis of emotions to make better stock-picking decisions. Technology is helping sentiment but whether or not sentiment is going to yield a long-term return is a different story.
The paper says: “Market participants are human beings. When faced with uncertainty, emotions affect the way they make decisions. For example, actual economic value created is the ultimate measure of the company’s true value and, by extension, the ultimate driver of its stock price.
“Companies demonstrate the economic value they generate in concrete ways – through their actual, delivered earnings, profitability and growth, leading in turn to dividends paid back to shareholders. But forecasting these dimensions of performance is extremely uncertain.
“This means that the way market participants, including professional investors, feel about companies – their perception of future earnings, profitability and growth – influences their stock-buying decisions and, at least in the near term, is a primary driver of equity prices.”
Engel says in her paper that making effective use of sentiment requires judgement and nuance.
“Recent months, for instance, have seen big changes in market leadership and market direction; these indicate broad changes in sentiment. The largest reversals in stock prices, broadly indicating increasingly negative sentiment, occurred in the retailing, paper and forest products, software and services, and technology, hardware and equipment sectors. The biggest stock-price increases, generally indicating increasingly positive sentiment, have been in metals and mining, consumer staples, telecom services and autos.
“These broad shifts in sentiment are interesting, but they are not, in our view, a basis to invest. We believe that a robust range of objective sentiment measures, understood in context with other investment themes, is crucial to convert the market’s collective emotions into useful, investable insights.”
In conclusion, Engel says: “As a forward signal of near-term price changes, sentiment is an important complement to fundamental-driven themes, which take shape over the long term. We believe sentiment is most useful when viewed alongside these longer-term signals. Over the past year, for example, many companies with positive sentiment have also been very expensive. In circumstances like this, we tend to prefer value…”