In the world of investing, the name Richard Driehaus stands tall, not just as a legendary investor but as the pioneering father of momentum investing. His philosophy, succinctly captured in the belief that stocks making significant moves on substantial news tend to continue in that direction, has reshaped how many people approach the equity markets.

I met Richard Driehaus in the early 90s when I worked for Russell Investments. One of the analysts had identified Richard as an incredibly unique and insightful money manager out of Chicago (he might have even called him excentric). Not knowing much about momentum investing at the time I joined the analyst the next time that Richard visited the Russell headquarters in Tacoma, Washington.

Keep in mind that at that time all the serious work in investment management was focused on valuation approaches, not momentum. Momentum was pretty much a dirty word best used to describe what traders did in the commodity pits. Not something that a respectable institutional investor would spend any time on.

It was only later that finance professors started researching momentum investing. In 1997 Mark Carhart extended the then widely used Fama-French 3 Factor model (market, value, and size) to also include momentum as a fourth factor. The Carhart model has become the standard asset pricing model among both academics as well as practitioners.

Momentum investing is predicated on the idea that stocks that have performed well in the past tend to continue performing well in the short term, and conversely, stocks that have performed poorly tend to continue underperforming.

Momentum investing works wonderfully when markets are calm and are trending up. The flip side is when markets experience stress and trend down. Momentum works, on average, because equity markets spend more time going up than down and has become an integral part of mainstream investing.

Understanding Market Momentum Cycles

Market cycles are the heartbeat of the financial world, a rhythmic pulsation of prices moving through phases of growth, stagnation, decline, and recovery.

These cycles are a reflection of the collective psychology of market participants, driven by a myriad of factors including economic indicators, corporate performance, global events, and speculative trends. Understanding these cycles is paramount for investors aiming to navigate the equity markets successfully.

There are many ways to identify momentum in prices. Some people simply look at the performance of a stock going back a year. Others are more focused on shorter holding periods such as a quarter.

I have been using a methodology that I developed over 20 years ago that evaluates where the stock is trading today versus its 3- and 12-month moving averages. It’s stood the test of time as a useful tool to examine the momentum characteristics of equity markets.

The methodology assigns each stock to one of six technical stages. Conceptually all stocks move through the six stages in a clockwise manner.

The journey of a stock is marked by several distinct stages, each representing a phase in its cyclical movement.

These stages are not merely academic; they offer investors a framework for understanding where a stock, or the market at large, stands within the broader context of its cyclical journey.

By recognizing these phases, investors can better anticipate potential shifts in market momentum and align their strategies accordingly. Investors can also use this tool to examine the internal health of the equity market.

Analyzing the Current US Equity Market

The current equity market is a tapestry of diverse trends, with stocks at various stages of their cyclical journeys. The analysis includes all common stocks with a market capitalization greater than $200 million traded on US exchanges.

• A snapshot of this environment reveals that 45% of stocks are in an Up Trend, showing strong momentum and investor confidence.

• Meanwhile, 18% are in a Down Trend, reflecting areas of concern or sectors facing challenges.

• The rest are scattered across the stages of Deterioration (16%), Break Down (8%), Improvement (7%), and Break Out (6%), indicating a market in constant flux, with stocks transitioning through the cycles of momentum.

Understanding the Market Distribution:

This distribution offers valuable insights into the broader market dynamics.

• The significant proportion of stocks in an Up Trend (45%) suggests a prevailing optimistic outlook among investors. This is attributed to favorable economic indicators, robust corporate earnings, and the prospect of lower interest rates.

• The stocks in a Down Trend highlight sectors of the market that are facing headwinds, such as industry-specific challenges, regulatory pressures, or macroeconomic uncertainties.

• The stocks in the Deteriorating, Break Down, Improving, and Break Out stages represent the market's undercurrents. Stocks in these stages are facing potential shifts in momentum and offering opportunities for strategic entry or exit points for investors.

• The current proportion of stocks in the Up Trend stage suggests an early to mid-innings bull market. It suggests that there is more to come and that the bull market in US equities is not near its end. A late-stage bull market tends to have at least 65% of all stocks in an Up Trend.

• The higher-than-normal (for an early to mid-innings market) proportion of stocks in the Deteriorating stage (18%) most likely reflects uneasiness about the direction of interest rates in the US.

Economic Sector Distribution:

The sector distribution of the technical Momentum scores highlights that not every sector is participating equally in the strong performance of Us equity indices especially in the large-cap space dominated by Tech names.

There appears to be a dichotomy behind those sectors that are very interest rate sensitive such as Utilities and Real Estate and the rest of the market.

• Utilities and Real Estate have the lowest proportion of stocks in the Up Trend stage. In addition, 36% of Real Estate stocks have moved into the Deteriorating stage most probably due to the lack of action by the Fed on cutting rates. 47% of utilities are in a Down Trend. Unless the Fed cuts rates this proportion is unlikely to change much.

• Interestingly, the media is hyper-focused on the contribution of Technology stocks to the performance of cap-weighted benchmarks such as the S&P 500 or the Nasdaq 100. On an equally weighted basis, Technology stocks don’t stand out. 48% are in the Up Trend stage with 19% in the Deteriorating stage. That’s in line with the overall universe.

• The current momentum cycle of the market points to the vulnerability of Financials. with 35% of stocks in the Deteriorating stage. Financials tend to perform better with a positively sloped yield curve. Market participants have been disappointed with the lack of an interest rate cut by the Fed which has dented sentiment in these stocks. That along with regional banking worries related to office space occupancy has led to a retrenchment among financial stocks.

Strategic Implications for Investors

The concept of price momentum, as highlighted by Richard Driehaus, is evident in the current market environment.

• Stocks that have entered an Up Trend are likely to continue their ascent, bolstered by positive investor sentiment and reinforcing the momentum investing strategy.

• Conversely, those in a Down Trend may continue to face challenges until a significant positive catalyst emerges to reverse their fortunes.

• The presence of stocks in the transitional stages of Deteriorating, Break Down, Improving, and Break Out signals the market's dynamic nature. These stages offer a fertile ground for investors to apply the principles of momentum investing, identifying stocks fundamentally poised for a change in direction before they fully embark on a new trend.

Navigating the equity market with an awareness of these momentum cycles and the distribution of stocks across the technical stages allows investors to position their equity portfolios advantageously.

By focusing on stocks in the Up Trend and Break Out stages while monitoring those in Deterioration or Break Down for potential shifts, investors can harness the power of momentum to their benefit.

Navigating the cyclical nature of the stock market requires a blend of strategic foresight, disciplined analysis, and an understanding of market psychology.

Recognizing the stages of market cycles and the momentum that drives stock movements enables a strategic approach to investing, aligning with the principles of momentum investing championed by Richard Driehaus.

The ability to identify the current stage of a stock or market cycle and anticipate potential shifts is invaluable for investors seeking to optimize their portfolios.

Here are key ideas to consider:

The Big Picture:

• Equities keep outperforming bonds. US large-cap equities faltered last week but international Equities and US Small Cap all had weekly returns greater than 1%.

• The big losers last week were holders of US Bonds as both inflation releases (CPI, PPI) exceeded expectations likely leading the Fed to slow down any potential rate cuts until the summer or fall.

• Cash is again outperforming bonds this year. Until there is more clarity as to the direction of Fed policy this situation is likely to persist.

• The investment environment remains risk-on. Aggressive asset allocation strategies continue their outperformance.

Economy:

• Last week saw increasing concerns that inflation may not be under control and certainly not close enough to the 2% Fed target

• The annual rate of consumer inflation stands at 3.1% which is in line with the long-term history of the US economy.

• Real rates are, however, only about 1% which should be manageable for most industries. Some industries such as housing are suffering but the culprit may be high asset values to begin with rather than high interest rates. Similarly, the recent spike in auto loan delinquencies is likely due to the jump in auto prices since the onset of the pandemic rather than onerous credit terms.

• Many investors are still thinking of the good old days of ultra-accommodative Fed policy. We are unlikely to see those days anytime soon barring an economic collapse similar to the Financial Crisis or COVID-19.

• Bond yields need to offer enough of a cushion over inflation to be attractive to investors. This is particularly true of retirees looking for income.

Equities:

• US Large Cap equities underperformed last week with the S&P 500 down 0.3% while the Small-Cap Index, the Russell 2000, returned 1.2%.

• Growth under-performed value for a change last week. The S&P 500 Value index was up 0.9% while its Growth counterpart went down 1.2%.

• Value-oriented sectors such as Energy, Materials, and Utilities performed the best last week while Tech dropped 2.6%.

• Stocks paying dividends had positive returns last week after a bit of a drought.

• On the international front, the MSCI China Index jumped up 3.7% as investors took comfort in the various government stimulus programs.

• Similarly, Japanese equities continued their resurgence with the MSCI Japan Index up 2.3%. The Japanese economy has technically fallen into recession lessening the possibility for rate hikes to support the yen. Lower rates for longer and a weaker yen are good for export-oriented Japanese equities.

Bonds:

• The US bond market is at the mercy of Fed policy. The economy is too strong to warrant cuts at the moment.

• Long-maturity Treasury bonds got hammered last week with the 20+ Year Treasury showing a 1.2% loss for the week.

• Year to date, all bond categories in the table below show losses.

• The least beaten-down bond strategies carry lower maturities and a degree of equity market risk (Convertibles and High Yield)

• The outlook for fixed income has improved compared to a year ago, but investors are still being held hostage by the Fed. I am not convinced that extending maturities is advisable at the moment.

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