March 6, 2013

Whatchamacallit?


In 1967, Bob Levy came up with the term relative strength in his paper "Relative Strength as a Criterion for Investment Selection." He soon afterwards wrote a book called The Relative Strength Concept of Stock Price Forecasting. Levy showed that stocks which outperformed the market over a pre-specified time period exhibited performance that tended to persist. Relative strength was a good name for this form of investing. When academics got a hold of the relative strength concept in the 1990s, they renamed it momentum. This was unfortunate, since momentum among practitioners also means investing in anything that shows price strength. I still run across this when uninformed investors want to dismiss momentum as something left over from the dotcom days.

In the early days, academics further defined momentum as "cross-sectional," since it was studied by sectioning the stock market into deciles or quintiles and comparing the top relative strength "winners" to the bottom relative strength "losers".

Recently, other researchers have discovered another form of momentum that looks at an asset's performance against its own past price action rather than against the past performance of its peers. This form of momentum was a key feature of my 2012 paper "Risk Premia Harvesting through Dual Momentum." I called it absolute momentum in contrast to relative momentum.

The researchers at AQR were also working on a paper published last year called "Time Series Momentum." To me, time series means something like ARMA or ARCH modeling, in which one studies a series of past prices. Moving averages are a time series. However, in absolute momentum one usually compares the current price to only a single past price in order to determine if the trend is up or down. I also prefer the term absolute momentum because practitioners are used to hearing about relative returns and absolute returns. Relative momentum and absolute momentum follow the same logic.

Some academics distinguish between only two types of momentum, what they call cross-sectional and time series momentum. In order to not confuse matters further, we will continue to use the terms relative and absolute momentum. You should be able to follow all the momentum players now without a program. Remember, a rose by any other name….