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Tuesday, April 28th, 2009

Still chasing the big mo — momentum

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When the market has made a big move I find it can be easy to lose focus on your strategy. There seem to be opportunities everywhere. I mean look at those stocks reversing their big falls, micro-caps are hot, speculative miners are moving again.

In situations like this it’s probably good to remind yourself of your edge every now and then. In my case it’s momentum – buying stocks that are already moving strongly.

As I’ve written before, momentum is an anomaly in the stock market that doesn’t conform to the Efficient Markets Hypothesis – ie it’s possible to beat the market buying momentum stocks. What’s more, despite it being well known, it doesn’t seem to have been arbitraged away.

So I’m chasing momentum.

Obviously momentum primarily refers to price: stocks prices that have been going up tend to keep going up. But do we buy stocks that have been going up after a day, a week, a month, three months?

Most research suggests that momentum is only significant based on gains over the past 6 to 12 months; ie stocks with big gains over the past 6-months or year or will tend to persist in going up.

This explains why many of the best aggressive-growth traders aren’t afraid to buy stocks that have made big moves.

In my review of my last bull market performance, I mentioned that many – if not most – of my most profitable trades were stocks that had already made gains of 100 per cent or more.

I’ve found that stocks really only have momentum when they are trading consistently above their rising 50-week moving average. That usually only happens after the stock has already made big gains.

Stocks with real momentum also tend to be trading close to, or at, 52-week highs. Again, they usually only get there after substantial gains.

Based on the above, screening for momentum stocks is also fairly obvious: biggest 12-month gainers and relative strength, stocks trading above rising 50-week moving average, stocks hitting 52-week highs.

But research also shows that in addition to price momentum, there are other characteristics of stocks and the broader market that help with momentum:

- High price-to-book value
- Accelerating earnings
- Upward profit guidance revisions
- Increases in analyst profit forecasts
- A bull market (which is why momentum traders also need a market-timing strategy)
- Industry momentum

All this has implications for a suitable strategy for the current market: most of the gainers at the moment are beaten down stocks reversing (at least in the Australian market). Yeah they’re on the move and have been for the past three months or so, but they don’t have real momentum; it’s a crap shoot.

It requires patience to wait for the market to heal and momentum stocks to set up. It’s also important to remember that, as Gil Morales has noted, sometimes we can start a bull market, but the momentum stocks only begin to move seriously some months later.

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Word Count: 487. This entry was posted on Tuesday, April 28th, 2009 at 11:53 pm and is filed under Uncategorized. 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.