Chase the Road Runner but don’t go over the cliff

Wile E. Coyote was the unlucky villain in the Road Runner cartoons. Looking for a meal, he would repeatedly chase the Road Runner only to always meet a temporary slapstick demise. No matter how horrible his accident would be, he somehow showed up for the very next segment in the cartoon’s episode.

As a kid, my favorite Wile E. Coyote catastrophe had him running off a cliff, somehow defying gravity to pause in mid-air to consider his misfortune, followed by an excruciatingly long fall ending in a puff of dust as he hit the canyon floor.

Momentum investment strategies remind me of Wile E. Coyote. Momentum investors often rush headlong into a hot investment, but instead of stopping before the cliff’s edge, their enthusiasm and disregard for fundamentals expose their portfolios to unanticipated risk. Portfolios that had been significantly outperforming suddenly significantly underperform.

For decades, we’ve argued that the key to successful growth and momentum investing is not necessarily what stocks one buys because it is relatively easy to identify earnings growth or price momentum. Rather the key to successful growth/momentum investing tends to be knowing what stocks to sell.

Chase the Road Runner, but don’t go over the cliff.

Where is the cliff’s edge?

It is virtually impossible for investors to determine the exact moments of a momentum strategy’s peak returns. But there can be hints that suggest reallocating portfolios, diversifying, and reducing potential risk before the peak is reached.

One of those hints has historically simply been extreme performance. When assets dramatically outperform or underperform, the probabilities start to increase that performance will reverse. This is called mean reversion.

Time horizon is typically critical when assessing whether asset prices could potentially mean revert. Over long periods of time, equities offer vastly superior returns relative to bonds or cash. However, when equity returns become extremely positive, the probabilities begin to increase that bonds or cash might outperform over the near future. The reverse is usually true.

The cliff’s edge seems reasonably close for NASDAQ...

Chart 1 highlights the distribution of 3-year total returns for the NASDAQ Composite broken down into quintiles. NASDAQ has appreciated over 30%/year over the last 3 years, and that very high return is among the highest 3-year return in NASDAQ’s history (i.e., the return is in the highest quintile of returns). In fact, it is more than double the “normal” (i.e., median) return for NASDAQ since the index’s inception in 1971.

3-year returns that were superior to the latest 3-year period’s returns were all during the Technology Bubble’s periods ending in 1998, 1999, and 2000.

...But not so close for the broader market.

Chart 2 compares similar distributions for the S&P 500® and the Equal-weighted S&P 500®. Through time the typical returns of the S&P 500® and the Equal-weighted S&P 500® were roughly similar. The median 3-year return for the Equal-weighted S&P 500® was 12.4% versus the S&P 500®’s 12.2%.

Today, the Equal-weighted S&P 500®’s return is very slightly higher than the long-term median return, but the S&P 500®’s current returns are nearly double the index’s median return.

The cliff seems closer for NASDAQ and the S&P 500®, but not for the Equal-weighted S&P 500®.

What happens after?

Chart 3 shows how various market segments and asset classes perform during the 3 years after NASDAQ’s extreme outperformance, i.e., what happens in the 3 years after NASDAQ’s trailing 3-year performance is in Quintile 1. The equity market tends to broaden, and NASDAQ performs poorly relative to other segments of the global equity market.

Our views should not be considered “bearish.” Rather, we are quite bullish on most of the bars to the left of the NASDAQ bar in Charts 3 and 4.

Don't go over the cliff

2022 was a miserable year for speculation within the equity market. NASDAQ was down nearly 33% for the year and the Magnificent 7 stocks were down 45%. Non-US stocks handily outperformed, and the equal-weighted S&P 500® was down only 11.5% and outperformed NASDAQ by almost 22 percentage points!

Investors should consider the probability of 2022 repeating in 2026. It’s clearly not 100% and it’s clearly not 0%, and every investor will have their personal assessment. That probabilistic assessment should help one decide the current level of diversification and risk reduction within a portfolio.

RBA’s portfolios are overweight non-US stocks, dividends, value, and some of the other characteristics contained in the left bars of the chart above. Our portfolios have been moving away from the edge of the cliff.