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STRATEGIES; Reassessing a Tactic When Its Momentum Begins to Slow

February 3, 2002 , Sunday

By MARK HULBERT (NYT)

EARNINGS momentum strategies have been losing steam, though it is too early to count them out.

The strategies favor the stocks of companies whose earnings are growing most rapidly, while shunning or even selling short those whose earnings are contracting the fastest. All exploit the tendency of investors to respond slowly to new information.

Rather than reacting immediately to a strong earnings report, for example, investors often bid up a stock gradually. Those who use earnings momentum strategies can make a profit by reacting more quickly. The profits have been large enough and enduring enough to impress skeptical academics.

Recently, however, the strategies have struggled. According to research by Ford Investors Services in San Diego , stocks with the highest earnings momentum had one of their worst years in 2001, not only relative to the market but also relative to strategies based on other popular stock selection tools, like the price-to-earnings ratio, dividend yield or relative strength. In the last three years, stocks with the highest earnings momentum lagged the market by more than they have over any other three-year period since 1974.

The editors of the investment newsletters that I monitor differ over what accounts for the recent struggles of these strategies.

One hypothesis focuses on the Securities and Exchange Commission's Regulation FD, which took effect in 2000. Regulation FD requires companies to release material information publicly, rather than privately to Wall Street analysts. Some newsletter editors think that Regulation FD reduces the market's reaction time to earnings information and therefore the profitability of earnings momentum strategies.

Many finance professors are skeptical about this hypothesis. Academic research suggests that deep-rooted psychological factors cause investors to react slowly to new earnings information. These factors have nothing to do with how companies communicate. For example, investors develop attachments to stocks they love and revulsion to those that have lost them money. They assimilate contrary information slowly, whether that information comes from an analyst or directly from the company.

In another hypothesis, earnings momentum strategies simply do not work in economic downturns. The rationale is that in boom periods, positive earnings momentum genuinely signals growth prospects. In downturns, companies that buck the trend tend to be the best defensive players, a trait that is admirable in a recession but that may have nothing to do with how well a company performs over the long term.

I am also skeptical of this hypothesis because there is no evidence suggesting that investors' reaction time becomes speedier in a downturn. In fact, the data suggest otherwise. Over the last 27 years, according to Ford Investor Services, there were four other years besides 2001 in which earnings momentum strategies lagged the average stock -- 1984, 1995, 1997 and 1999. The economy grew in all four of those years.

There is another explanation why earnings momentum strategies have languished: It may be that so many advisers and investors have started to use earnings momentum strategies that they have begun to kill the goose that lays the golden egg. This is the likely fate of any strategy that becomes too popular, and it is consistent with data showing that these strategies have found it tougher in recent years.

But it is premature to conclude that this is the case for earnings momentum. Given the strategies' stellar long-term record, it will take many more years of mediocre performance to persuade statisticians that this recent experience is not an exception. Since the alternative is giving the boot to every strategy as soon as it stops working, an approach that we know does not work over time, the intelligent bet in the meantime for followers of earnings momentum strategies should be to stick to their guns.

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