Stock Investing Using Momentum

Investors can find winners and avoid losers by using momentum. We explore momentum and how investors can use it in their strategy.

Momentum Stocks: A Stock in Motion Tends to Stay in Motion

Momentum investing is an approach that involves buying stocks that have gone up the most. Unlike other fundamental investing methods that look at financials or valuations, momentum cares only about one thing: the price strength (or weakness) of a security to determine whether it is a buy or sell.

Because prices are always changing in the market, momentum investing tends to be considered as more of an active investment strategy. So, investors deploying momentum need to take into consideration market liquidity, transaction costs and tax consequences. Studies have shown that momentum persists in different markets and asset classes, making this investment factor a powerful predictor of intermediate term returns.

Some may hear the word momentum and automatically think it is similar to growth investing, but that is not true. High momentum stocks can sometimes be value stocks, utility stocks, cyclical stocks or technology stocks. Different sectors, industries, styles and sizes of stocks perform differently throughout economic and market regimes, and as investor preferences change. Momentum has the ability to go anywhere in the market, seeking out those areas that are performing best, making it a versatile strategy for investors.

Types of Momentum and How to Measure It

Momentum can be measured in multiple ways. Here are the more popular methods, along with specific momentum indicators that investors can utilize.

• Relative Momentum: This form of momentum measures stocks relative to each other. Stocks with the best performance over a period of time, say a year, are the favored securities and the worst performers are avoided. Research has shown that intermediate term momentum between three and 12 months tends to work best. Relative strength, which is just a ranking of stocks from one to 99 (with 99 being the best) based on their past 12 month returns, is one way to measure momentum. Research has shown that excluding very short-term momentum, such as the most recent month, can improve momentum’s effectiveness since very short-term momentum can be prone to sharp reversals. Another measure, 12 month minus 1 month momentum, addresses this by looking at the performance of a stock over the last 12 months excluding the most recent month.
• Absolute Momentum: This type of momentum compares the stock to itself. For example, if over the last nine months, the performance is positive, this would indicate that the investor should stay invested in the stock. If the performance turns negative, it would warrant the investor to consider selling the security. The higher (or lower) the absolute momentum is on a stock, the better (or worse) it would be for buying (or selling) it. A stock trading above or below a moving average, such as the 50- or 200-day moving average, is another example of an absolute type of momentum signal.
• Dual Momentum: Dual momentum combines relative and absolute momentum. A dual momentum strategy may look for stocks that have positive absolute momentum and relative momentum, while avoiding stocks with negative absolute momentum and relative momentum.

There is also research to support that a more consistent momentum is better than inconsistent momentum. If you have two stocks that are up 50% over the past six months, the stock with the more consistent path to generating its return is likely to be the better pick of the two securities based on momentum.

Why Does Momentum Work?

There are varying theories as to why momentum investing works. Some investors believe that momentum stocks are riskier and that they should be compensated for that risk with greater returns than the overall market. But some of the leading experts tend to credit behavioral biases as the likely driver of the momentum premium.

• Experts believe momentum exists due to investor overconfidence and skepticism, where skeptics sell too early, giving room for further upside in stocks as positive market developments take hold.

  Other possible behavioral tendencies that may explain why momentum works include:

• Cognitive Dissonance: Investors tend to react more logically to information that confirms their beliefs and discount information that runs counter to their thinking. As a result of this, momentum may take hold more easily.
• Inattention: Investors tend to under-react to a number of small changes vs. one less frequent major change. Because of this, price anomalies like momentum can exist.
• Disposition Effect: This idea centers around holding losing stocks for too long and selling winning stocks too early. Because investors feel the pain of losses more than the joy of gains, many avoid selling losing stock positions and instead sell those with gains.

In addition, high momentum in a stock may turn out to help a company’s underlying business, a concept called reflexivity. Companies with strong performing stocks may be able to use an elevated stock price to make profitable acquisitions, attract the best and brightest talent, compensate their workers through lucrative stock options and even issue new equity where the proceeds can be used to fund various strategic initiatives or positive financial developments (i.e., paying down debt). Strong momentum stocks may benefit from a positive feedback loop where fundamentals eventually benefit from the strength of the stock.

This approach doesn’t come without risks. When looking at short-term momentum, reversals can happen regularly. For example, stocks with the best one-month performance are likely to underperform in the following month. This is one of the key reasons why intermediate term momentum is utilized by most momentum investors – it helps avoid this reversal effect. Also, when market leadership transitions from one type of stock to another, a momentum strategy will have to adjust and can struggle.

Finding Winning Stocks with Momentum

Momentum investing involves buying stocks that have performed best over an intermediate term time horizon and avoiding those that have performed the worst. Momentum can be measured using relative metrics, like Relative Strength or 12 minus 1 month momentum, or on an absolute basis.

On Nasdaq, you can see the top scoring momentum stocks on a daily basis. These are the names in today’s market that are exhibiting both the highest price momentum and strong fundamental momentum, which measures the trend of improving fundamentals over time.

See the Top Scoring Momentum Stocks in Today’s Market

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