Can Fundamental Momentum Diagnose Mr. Market?

Ben Graham, the father of modern value investing, introduced his Mr. Market analogy back in 1949.

As Graham saw it, whenever you invest in the stock market, you partner with the moody Mr. Market. Each day he offers you a choice: sell to him, buy from him, or do nothing. His daily mood determines the price that he is willing to offer or accept, and it is up to you alone to decide what to do.

Unless you live on a deserted island, you know Mr. Market has been going through a rough patch lately, hopping on and off the psychiatrist’s couch more often than usual.

So let’s see if big data can help us diagnose and anticipate Mr. Market’s mood.

Mr. Market’s Split Personality

Mr. Market has two sides to his personality. His rational side analyzes hard data and bases decisions purely on the facts. But he is also emotional: He can get variously excited, panicky, and depressed, and when he does, he lets those feelings take over.

Mr. Market’s rational vs. emotional internal conflict parallels the fundamental vs. technical divide in investment analysis.

Fundamental analysis (FA) examines a firm’s intrinsic value and tries to evaluate it either on its own or relative to its price. A stand-in for Mr. Market’s rationality, FA tries to keep a cool head and measure the market economics, filtering out the noise from other investors and the loud headlines in the media or on social networks.

Technical analysis (TA) explores Mr. Market’s emotions, studying the statistical behavior of equity prices and predicting price movements based on Mr. Market’s past patterns. A typical TA method might favor stocks that are rising on a steady incline, joining in on the exuberance. Whatever the “wisdom of the crowd,” according to this approach, the investor should simply follow it. TA can be applied to any asset with a time series of prices and a free market, regardless of its nature

How FA and TA relate to Mr. Market’s rationality or emotions, respectively, is straightforward enough. Anticipating when Mr. Market will decide to follow his brain or his heart is far more complicated. During the 1999–2000 tech bubble, for example, Mr. Market took a rather excitable approach, while he embraced a rational outlook in the solid recovery of 2003–2004.

The precise moment when Mr. Market will lose his temper, give in to irrational exuberance, or otherwise succumb to TA emotions is impossible to predict. In the long run, however, he does eventually rediscover FA rationality. Investors just have to wait for him to come to his senses. As Warren Buffett summed up centuries of experience across various geographies and trading regimes, “The stock market is a device for transferring money from the impatient to the patient.”

Fundamental Momentum as a Gauge of Mr. Market’s Mood

Combining the best aspects of FA and TA, our proposed Fundamental Momentum strategy helps anticipate Mr. Market’s mood swings. It does so by generating a Market Quality Index (MQI) based on individual company grades, each determined from multiple quantitative fundamental factors.

Markets are expectations-driven and usually react to changes. A likely improvement in sentiment can push markets up, while an anticipated deterioration depresses them. This is where the momentum of the MQI, defined as the Fundamental Momentum, comes into play. Improved, declining, and unchanged fundamentals yield higher, lower, or average grades, respectively.

Fundamental Momentum marries the data-grounded approach of FA — the rational side of Mr. Market — with his emotional, momentum-based instincts.

The investment strategy that tests Fundamental Momentum is driven by MQI movements over the longer term rather than month to month. Specifically:

• With positive or stable MQI momentum, the strategy stays invested in the risky asset to profit from Mr. Market’s buoyant mood, which is likely to bid up stock prices
• With negative MQI momentum, the strategy reverts to cash or low-risk assets to avoid taking a hit as  Mr. Market dumps stocks indiscriminately.

Dodging Three Bear Markets

How did the Fundamental Momentum indicator, as analyzed and simulated by Alpha Vee Solutions, work during Mr. Market’s most recent dramatic fits, in 2008–2009, 2011, and 2015–2016? The graphs below explore this question. The green bars represent the monthly value of the price-independent MQI. The blue and red lines are the S&P 500 Total Return Index and the Fundamental Momentum investment strategy, respectively, both rebased to 1.000 at the beginning of each examination period.

Fundamental Momentum 2008–2009

Source: All charts courtesy of Alpha Vee Solutions.

Fundamental Momentum 2011

Fundamental Momentum 2015–2016

Fundamental Momentum anticipates when to step away from stocks and into the safety of cash before Mr. Market sinks to the depths of despair.

Importantly, fundamental momentum returns to risky assets in a disciplined fashion, even when it runs counter to conventional wisdom, like in the spring of 2009, when all headlines were screaming that Mr. Market would never smile again.

Active return, or alpha, from Fundamental Momentum was 2% annualized with a 0.42 beta over the 16-year period from 2002 to 2017. This outcome was achieved with a Sharpe ratio double that of the S&P 500, as volatility measured by the standard deviation fell to single digits.

Fundamental Momentum delivered on its promise, capturing 67% of the upside and suffering only 45% of the downside.

Fundamental Momentum Is Universal

Fundamental Momentum works for smaller universes of stocks as well.

The graph below applies Fundamental Momentum to the health care sector in 2016. The blue line represents the S&P Healthcare Index and the green bars are the MQI calculated from more than 100 health care companies. That year, health care had something of a manic phase: The sector fell 8% in the first two months, rose 14.6% over the following five months, and then dropped 10% over the next four.

Fundamental Momentum: Health Care 2016

Like any method, Fundamental Momentum is not a miracle cure. Occasionally, it can be late exiting or entering the market: With health care, the strategy missed the price upswing from February to May 2016.

On the whole though, Fundamental Momentum is a useful tool that provides a rational approach to understanding market swings and reducing volatility.

Mr. Market may be mercurial. But Fundamental Momentum can help investors better anticipate his mood swings.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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