Deep Dive: This momentum-stock strategy can be a winner regardless of whether the Federal Reserve pivots

Investors are looking ahead to the end of the major trend of 2022 — rising interest rates, which halted the liquidity-driven bull market and pushed people away from stocks. So far this year, lower-volatility strategies have held up better than the benchmark S&P 500 SPX, -1.11%.

The S&P 500’s market-cap weighting means it rewards winners in the index by giving them a larger presence. But it can be punishing during a broad decline for the same reason.

And the market may be shifting because this week’s consumer price index report showed a decline in inflation. Following that improvement, the Federal Reserve slowed the pace of its interest rate increases on Wednesday.

But Kalivas suggests caution: “The market may be too willing to embrace the notion that we will revert to a low-inflation environment,” he said, referring to the November Consumer Price Index report.

“If you look at services, excluding energy, on a year-over-year basis, the rate of change hit a new high. Services are a big portion of the economy,” he said. Next year he expects a “continued elevated volatility dynamic” for stocks.

Momentum strategy beats the S&P 500

This year, low-volatility strategies have held up well. For example, the Invesco S&P 500 Low Volatility ETF SPLV, -1.06% was down only 2.9% through Dec. 13, while he SPDR S&P 500 ETF Trust SPY, -1.18% was down 14.4%. (All returns in this article include reinvested dividends.)

Now let’s look at how those ETFs have performed against two momentum strategies over longer periods:

The first three columns show total returns through Dec. 13. Those reflect this year’s broad declines. So it might be interesting to have total returns that encompass the bull market that ran through 2021, when years of very low interest rates and stimulus by the federal government and Federal Reserve pushed so much money into stocks. These are in the right-most column.

Aside from 2022, when the low-volatility strategy has been the best performer, the Invesco S&P 500 Momentum ETF SPMO, -1.01% has outperformed for all periods on the table.

SPMO holds the 100 stocks in the S&P 500 have have the highest trailing “momentum scores” going back 12 months (but excluding the most recent month) when the portfolio is reconstituted and rebalanced. This happens twice a year, on the third Friday of March and September. The stocks are then weighted by momentum score, but also scaled by market cap.

In its analysis of SPMO’s strategy, FactSet says: “Adjusting for volatility in this manner tilts the fund toward stocks that have experienced a relatively smooth increase in price.”

FactSet also says SPMO “can produce major biases” to the market sectors that have been the best recent performers. All of this means 29% of the fund’s portfolio is now in the energy sector, according to Invesco. But you might be surprised that health-care stocks make up 31% of SPMO’s holdings. The fund’s top holding is Exxon Mobil Corp. XOM, -0.70%, which makes up 9% of the portfolio.

So far in 2022, the energy sector has been, by far, the strongest of the 11 sectors of the S&P 500, with a return of 61.6%, while the health-care sector has essentially been flat, with many strong performers, as reflected in SPMO’s concentration.

Looking ahead, Kalivas says the setup for energy is still good, in part because the U.S. needs to refill its Strategic Petroleum Reserve, after President Biden decided to release oil into the market to help ease price pressure. He cited the domestic oil industry’s continued reluctance to invest in supply expansion, and also said oil and natural gas producers “are probably still at the lower end of [their historic ownership] range within the S&P 500, and the stocks are  not overpriced.”

But he also emphasized that SPMO will react to price momentum regardless of which sectors are favored by investors.

Reconstituting and rebalancing the portfolio only twice a year might make you wonder if it might be better to make adjustments more often. This is why the performance table above includes the SPDR S&P 1500 Momentum Tilt ETF MMTM, -0.82%, which takes a broader approach and is reconstituted four times a year. It is also cap-weighted, with Apple Inc. AAPL, -1.46% the top holding, making up 8% of the portfolio.

SPMO has a five-star rating (the highest) from Morningstar, in the financial data firm’s “U.S. Fund Large Growth” category. The other three ETFs on the table have four-star ratings.

Top holdings of the momentum ETF

The Invesco S&P 500 Momentum ETF was last reconstituted/rebalanced in September. Here are its top 10 holdings, reflecting price movement through Dec. 13:

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