Remembrance of Stocks Past

Mark Hulbert has an article in the New York Times on one of my favorite topics—momentum investing. The issue I take with Mark is that he focuses on the intermediate-term impact of momentum. The impact where momentum has been most strongly felt is in the short-term. The shorter the term, the stronger it is. Historically, the impact has been very real and quite large. Whether it will continue is another question, and I tend to doubt it will.
The article contains this quote:

“We can be comforted by the fact that reasonably efficient markets always base their level on anticipated future returns,” he added, “and do not include history in the calculation.”

Sorry, but that’s just not true. One of the mysteries of the stock market is that the past does have an effect on the future. What it is and how it works isn’t exactly clear. For example, the stock market does significantly better on days following up days, and significantly worse on days following down days. Also, the persistence of tall heads and fat tails suggests (but isn’t proof) that the past impacts the future. In other words, stocks may go down simply because they’re going down.
Hulbert then goes on to discuss one area of market inefficiency which is the historical outperformance of small-cap stocks. Interestingly, this is the one anomaly that I’m most skeptical of. Historically, the numbers back it up but the small-cap premium is highly volatile compared with its size. In fact, small-caps have experienced decades of lagging the market.
I’m currently reading Eric Falkenstein’s fascinating book, Finding Alpha which discusses the small-cap premium and suggests that it may be an illusion due to methodological errors. I suspect he’s right. The January Effect doesn’t make much sense without it.

Posted by on January 4th, 2010 at 3:47 pm


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