Thursday, November 27th, 2008
Yes, momentum trading systems can win in a bear market
How has my system performed in this bear market? I’m pleased – at the moment – because it has kept me out of the market.
As I’ve mentioned before, my system is to buy aggressive-growth/momentum stocks in a bull market, and short in a bear market. I haven’t done as much short selling as I’d have liked because the past year has been a transition period with the birth of our first child and a move to self-employment.
Momentum trading gets a bad name for a number of reasons. Firstly it is viewed as a bit racy. People are suspicious of traders who jump into stocks for a quick ride and then hop off. In my view, however, momentum traders are allocating capital to the fastest-growing companies in the economy.
They are also likely to be bearing risk. The momentum premium in stocks has been well documented by academics. They have found that stocks going up tend to keep going up. Momentum stocks also generate higher returns than the market. The premium is one of the biggest challenges to the Efficient Markets Hypothesis, which says it’s impossible to earn higher returns than the market without bearing extra risk.
But in reality academics just probably haven’t found an explanation why momentum stocks are riskier for which investors are compensated with higher returns, as is the case with small and value stocks.
So while momentum traders are viewed as racy spivs, they probably have more theoretical/academic underpinnings than almost any other market participants. (Though I do concede many academics believe practical implementation of momentum trading is difficult to impossible)
The other reason the strategy has a bad name is because aggressive-growth/momentum funds have a habit of soaring and flaming out. But that doesn’t mean individual traders should ignore it as a strategy. These funds are obliged to stay invested 100 per cent, or close to, in aggressive-growth/momentum stocks throughout the entire market cycle. If you market a fund as aggressive growth, you can’t wake up one morning during a bear market and tell the investors that it’s suddenly a large-cap value fund.
The problem is that while aggressive growth stocks go up faster than other stocks in bull markets, they fall faster in bear markets. Buying and holding an aggressive-growth fund or portfolio of stocks is meaningless: you’ll have a wild ride, but get nowhere; or at least end up in the same place as the general market.
The only way to make momentum trading work is to be able to move to cash – 100 per cent if necessary – during a bear market. Private traders can do this. When momentum stocks inevitably start tanking, you sit that part of the cycle out. Admittedly it requires patience.
Ironically buying momentum stocks – stocks that are going up rapidly – is the best market-timing tool in my arsenal. The logic is pretty simple: the market doesn’t go up if no stocks are going up. (The equation is also reversible: no stocks are going up if the market doesn’t go up) I only buy stocks that are going up. In a bear market there aren’t any. So I’m forced to be 100 per cent cash, as has been the case over the last year or so.
I must note that a stock ‘going up’ is not a stock that is having a rally in a steep downtrend. You can tell a bear-market rally when the stocks making gains are simply reversing steep downtrends. A stock going up is one that has made a decent move of at least 20 to 30 per cent over a few months. (I jump on board when there are signs it is going to keep going).
Despite its bad name, the ability of a momentum system to both earn a premium over the market and as a market-timing device makes it a difficult strategy to beat.
Word Count: 640. This entry was posted on Thursday, November 27th, 2008 at 4:46 am and is filed under Momentum. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.
November 27th, 2008 at 4:57 pm
[...] Yes, momentum trading systems can win in a bear market But in reality academics just probably haven’t found an explanation why momentum stocks are riskier for which investors are compensated with higher returns, as is the case with small and value stocks. … [...]