In an era increasingly defined by proactive monetary and fiscal policy, understanding the cyclical and often opposing behavior of Value and Momentum investment factors is paramount for effective portfolio construction.
This report demonstrates that monetary policy, particularly the interest rate cycle, acts as a primary driver of factor rotation. Expansionary conditions tend to favor Momentum, while restrictive policies often set the stage for a Value resurgence.
Fiscal policy, through mechanisms like direct stimulus, can create liquidity conditions that further amplify momentum trends, sometimes detaching asset prices from their fundamental anchors.
The Philosophical Divide: Defining Value and Momentum
To comprehend how different investment strategies react to policy stimuli, it is essential to first establish their foundational principles. Value and Momentum investing represent two of the most well-documented and philosophically distinct approaches to equity markets.
Their core tenets, methodologies, and underlying market views dictate their divergent performance paths in response to macroeconomic shifts.
The Value Paradigm: From Graham to Modern Systematics
The Value paradigm is an investment philosophy centered on purchasing securities for less than their calculated intrinsic worth.
This approach, first formalized by Benjamin Graham and David Dodd at Columbia Business School in the 1920s, is rooted in the concept of a “margin of safety”—the discount between a stock’s market price and its intrinsic value, which provides a buffer against analytical errors or unforeseen adverse events.
The methodology relies heavily on fundamental analysis, which involves a meticulous study of a company’s financial statements, competitive positioning, and overall financial health to estimate its true value. In modern systematic applications, this analysis is often quantified through specific metrics.
At its core, value investing is predicated on a rejection of the strong form of the Efficient-Market Hypothesis (EMH).
It posits that markets are not always perfectly rational and can misprice assets in the short term due to investor psychology or neglect, creating opportunities for disciplined investors to buy assets at a discount and wait for the market to recognize their true value.
The Momentum Anomaly: Riding the Wave of Market Psychology
In stark contrast to the contrarian nature of value investing, the Momentum anomaly is a strategy based on buying recent winners and selling (or shorting) recent losers.
The strategy typically identifies these trends based on an asset’s relative performance over the preceding three to twelve months, operating on the belief that an existing price trend will persist for some time.
This approach directly challenges the classic market adage of “buy low, sell high,” instead advocating for what momentum pioneer Richard Driehaus termed “buying high and selling at even higher prices”.
Momentum strategies primarily rely on technical analysis, using price and volume data to identify and confirm trends rather than focusing on a company’s underlying fundamentals. Common tools include moving averages, such as a 50-day moving average crossing above a 200-day moving average as a buy signal, and other indicators like the Relative Strength Index (RSI) or Moving Average Convergence Divergence (MACD).
The existence of momentum presents a direct challenge to the weak form of the EMH, which states that past price movements cannot be used to predict future prices.
Value Investing
Momentum Investing
The Modern Market Context: Anatomy of a Policy-Driven Environment
A “policy-driven market” is one where the actions of central banks and governments are primary determinants of asset prices and investor behavior, at times overshadowing traditional company fundamentals.
Understanding the specific mechanisms through which monetary and fiscal policies influence the market is crucial for contextualizing the performance of Value and Momentum strategies.
The Monetary Lever: Central Banks as Market Movers
Central banks, such as the U.S. Federal Reserve, aim to achieve macroeconomic goals like stable prices and maximum employment through the implementation of monetary policy.
Their primary tools include open market operations (buying and selling government securities), adjusting the discount rate, and setting reserve requirements for banks. These tools have a profound impact on financial markets through two main transmission mechanisms.
Transmission Mechanism 1: Interest Rates and Valuation The most direct link between monetary policy and stock prices is through interest rates. According to the discounted cash flow (DCF) model, a widely used valuation method, a stock’s price is the present value of its expected future cash flows.
The formula involves a discount rate, which is heavily influenced by prevailing interest rates, to bring those future earnings back to today’s dollars.
Transmission Mechanism 2: Liquidity and Risk Appetite Expansionary monetary policy, such as lowering interest rates or engaging in unconventional measures like Quantitative Easing (QE), injects liquidity into the financial system.
QE involves the central bank purchasing long-term securities from the open market to increase the money supply and encourage lending and investment.
The Fiscal Impulse: Government Spending and Market Behavior
Fiscal policy refers to a government’s use of spending and taxation to influence the economy. While often aimed at the real economy, fiscal actions can have direct and powerful effects on financial markets, particularly when they involve large-scale, direct transfers to households.
The response to the COVID-19 pandemic provided a clear case study. The distribution of direct stimulus checks in the U.S. was empirically linked to significant increases in retail trading activity.
Research from Harvard Business School found that these stimulus-fueled inflows were not spread evenly across the market.
Instead, they disproportionately targeted stocks that already had high retail interest, such as those with a large number of Robinhood users, as well as stocks with lower market capitalization, low nominal prices, and high volatility.
These monetary and fiscal policies do not operate in isolation; they are often intertwined and can create powerful feedback loops.
For instance, an expansionary monetary policy that includes QE involves the central bank buying massive quantities of government bonds.
A Historical Dissection: Performance Across Policy Regimes
The theoretical links between policy and factor performance are borne out by historical data.
Examining how Value and Momentum have performed across different monetary and economic cycles reveals predictable patterns of rotation, highlighting their opposing sensitivities to the prevailing market environment.
The Interest Rate Cycle: A Tale of Two Factors
The interest rate cycle, dictated by central bank policy, is one of the most powerful drivers of factor leadership.
Rising Rate Environment: Historical analysis shows that Value stocks tend to perform well during periods of rising interest rates. As established, their front-loaded cash flows make them less sensitive to a higher discount rate.
Furthermore, rising rates often coincide with periods of economic expansion, which benefits the cyclical sectors like financials, energy, and industrials that are heavily represented in value indices.
Falling Rate Environment: Conversely, periods of falling interest rates have historically been more favorable for Momentum and challenging for Value. Lower rates increase the present value of distant earnings, boosting the valuations of the long-duration growth stocks that frequently exhibit strong momentum.
Static Rate Environment: In periods where interest rates are stable, market leadership becomes less clear. Some evidence suggests that without a strong directional policy signal from the central bank, the market tends to revert its focus to company fundamentals.
In these static periods, Value and other fundamental factors like Profitability and Investment have been the best performers, while Momentum has been among the weakest.
Factor Performance Across Interest Rate Regimes
| Factor | Rising Rates (Avg. Return) | Falling Rates (Avg. Return) | Static Rates (Avg. Return) |
| Momentum (MOM) | +20.2% | +13.9% | Weakest Performer |
| Value (HML) | +6.6% | -3.6% | Best Performer |
| Source: Analysis based on data from NCPERS research.26 |
The Economic Cycle: Navigating Recessions and Recoveries
The business cycle, with its distinct phases of recession and recovery, creates sharp inflection points that expose the fundamental risks and opportunities of each factor.
Performance During Recessions: Factor performance during recessions is nuanced. Momentum can hold up well, particularly in the early stages, as defensive trends that began pre-recession can persist.
Value’s performance, however, is highly dependent on the recession’s catalyst. In downturns caused by the bursting of an asset bubble (e.g., the 2000-2002 tech bust), Value strategies have historically excelled as overvalued growth stocks collapse back to earth, leading to an average outperformance of 34%.
The Momentum Crash: The most significant risk to the momentum strategy is its susceptibility to large, rapid drawdowns. These “crashes” are not random; they tend to occur at major market turning points, particularly in the recovery phase immediately following a recession.
Performance During Recoveries: The post-recession recovery phase is where the performance divergence between the two factors is most extreme. This period is often characterized by cautious optimism and a renewed appetite for risk.
Historically, Value and Small-Cap stocks are the strongest performers in the 12 months following a recession trough.
Factor Performance Across Economic Cycles
| Factor | Avg. Performance During NBER Recessions | Avg. Performance in 12 Months Post-Recession |
| Momentum (MOM) | Flat to slightly positive; varies by recession type. | Significant Underperformance (-3.6% avg.). |
| Value (HML) | Varies by recession type (strong in bubble bursts, weak in fundamental shocks). | Strong Outperformance (+8.8% to +24% avg.). |
| Source: Analysis based on data from Research Affiliates and Russell Investments. |
The Unconventional Era: Performance in the Age of QE and Fiscal Stimulus
The period following the 2008 Global Financial Crisis was characterized by unprecedented and sustained policy intervention, including near-zero interest rates, multiple rounds of QE, and, later, massive fiscal stimulus.
This environment proved uniquely favorable to Momentum and deeply hostile to Value. The constant injection of liquidity suppressed market volatility and encouraged trend-following behavior, conditioning investors to “buy the dip” and reinforcing prevailing trends.
Synthesis and Strategy: A Unified Approach for a Policy-Driven Future
The historical analysis of Value and Momentum’s opposing behaviors provides a clear foundation for building more resilient investment portfolios.
Rather than choosing between the two factors, a strategic synthesis that leverages their complementary nature offers a superior path forward in a market environment that remains heavily influenced by policy decisions.
The Power of Negative Correlation
One of the most robust findings in empirical finance is that Value and Momentum strategies are negatively correlated with each other, a phenomenon that holds true both within and across diverse asset classes, including equities, bonds, currencies, and commodities.
This negative correlation is not a statistical coincidence. It is a direct consequence of their opposing performance patterns across different market regimes, as detailed in Section 3.
Value thrives when trends break and mean reversion occurs (e.g., market recoveries), which is precisely when Momentum strategies experience their most severe drawdowns.
This relationship can be partly explained by their opposite exposures to underlying risk factors.
Academic research has shown that Momentum returns are positively related to liquidity risk (i.e., momentum performs well when liquidity is abundant), while Value returns are negatively related to it.
This implies that part of their negative correlation is driven by their opposing reactions to changes in funding conditions, which are themselves heavily influenced by central bank policy.
Constructing a Resilient Portfolio: Blending Value and Momentum
Given their strong negative correlation and individually positive long-term expected returns, a simple combination of Value and Momentum can produce a portfolio with a smoother return profile and a higher risk-adjusted return (Sharpe ratio) than either strategy in isolation.
This blended approach offers a “natural hedge” that is internal to the equity portfolio itself.
There are several ways to implement such a strategy:
Equal-Weighting (EW): This is the simplest approach, involving a static 50/50 allocation to both Value and Momentum factor portfolios. It systematically captures the long-term diversification benefit.
Dynamic Risk-Weighting (RW): This is a more sophisticated method that dynamically adjusts the allocation based on the prevailing market environment.
For example, a risk-weighted strategy might reduce its allocation to Momentum and increase its allocation to Value following periods of high volatility in the momentum factor, which often precede crashes.
One such backtested strategy demonstrated double the cumulative return and half the maximum drawdown of an equal-weighted blend by systematically de-risking from momentum during its most vulnerable periods.
Outlook for 2025 and Beyond: Positioning in the Current Policy Landscape
Applying the historical framework to the current economic outlook provides a guide for strategic positioning.
Synthesizing the 2025 Outlook:
Monetary Policy: The consensus forecast indicates that the U.S. Federal Reserve will begin an easing cycle, with expectations for two rate cuts in the second half of 2025, bringing the policy rate down from its restrictive stance.
Fiscal Policy: The U.S. is projected to continue running a substantial budget deficit of $1.9 trillion, equivalent to 6.2% of GDP. This implies a high level of government spending and bond issuance will persist, contributing to market liquidity.
Economic Growth: Projections call for modest but positive real GDP growth of approximately 2% for the U.S. economy.
Applying the Historical Lens:The 2025 outlook presents a complex and transitional environment for factor investors.
The anticipated shift to rate cuts in the latter half of the year would, based on historical data, suggest a more favorable backdrop for Momentum. The continued large fiscal deficit also points to a high-liquidity environment that has historically supported trend-following strategies.
Strategic Recommendation:The current outlook reinforces the strategic imperative for a blended, risk-managed approach. A dynamic risk-weighted strategy appears particularly well-suited for this environment.
Such a strategy would allow a portfolio to participate in any momentum trends that may be fueled by renewed monetary easing while providing an automatic mechanism to de-risk from momentum and rotate toward value if volatility spikes—a key historical indicator of an impending market turn.
Conclusion
The enduring debate between Value and Momentum investing is best resolved not by choosing a victor, but by recognizing their symbiotic relationship. In a modern market where government and central bank policies are primary drivers of returns, these two factors represent opposing but complementary forces.
Historical analysis clearly shows that their leadership rotates in response to predictable shifts in monetary policy and the broader economic cycle.
The persistent and structurally-driven negative correlation between them is the single most powerful tool available for building a resilient, all-weather equity portfolio.
The optimal strategy for navigating the uncertain policy landscape of the future is not to attempt to predict the next turn in the cycle, but to construct a disciplined, blended portfolio that systematically harnesses the inherent diversification benefits of these two fundamental market anomalies.