Momentum is one of the most powerful and yet misunderstood factors in the market. At its core, momentum is the tendency for a rising stock to continue rising, and a falling stock to continue falling. It sounds too simple to be true, yet countless academic papers have documented the existence of momentum in markets around the world.
In a ground-breaking 1993 paper, two UCLA professors found that stocks with strong past performance tend to continue to outperform stocks with poor past performance, with an excess return of about 1% per month (keep in mind that excess returns of 1% per month add up quickly). At the time, most of the financial community ignored the findings because they didn’t fit with existing theories of how the market worked. It was only with more academic evidence and real life success stories like AQR Capital Management that investors began to recognize momentum as the most significant factor explaining stock returns.
Although there are several theories explaining why momentum exists, the most convincing has to do with investor psychology. When looking at winning stocks, many investors are hesitant to buy a stock trading at a new high, or close to a new high. However, these stocks are more likely to announce positive earnings and upside surprises which can justify a higher price. As the higher price becomes justified, a rush of new investors who previously hesitated are finally motivated to buy, creating a positive feedback effect. For losing stocks, the opposite tends to be true; stocks making new lows are more likely to disappoint on earnings announcements and drive the stock price even lower. In 1987 George Soros wrote at length about this phenomenon in his book, The Alchemy of Finance, calling it “reflexivity”.
Even with powerful results, some investors still have reservations about using momentum in their portfolios -- “what goes up must come down” is the most common reason I’ve heard. I agree that there is a finite lifespan to momentum, but that’s also been well documented. In an earlier 1985 paper, researchers De Bondt and Thaler found that stocks that have been trending for three to five years often reverse course at that time, beginning a new trend in the opposite direction. So, using simple risk controls like a line-in-the-sand exit price can keep investors out of reversals when they inevitably occur. For investors seeking additional comfort, such as in the Growth and Income Portfolios, investing only in positive momentum stocks, and not short selling the negative stocks, can simplify momentum even further without giving up performance.
I believe that momentum is currently undergoing scrutiny the same way fundamental value investing did in the 1930s. Both concepts were considered new for their time, both were first researched and documented in an academic setting, and both were initially ignored by investors. As access to company financial reports became standardized, value investing grew into the mainstream. Today, with access to price histories becoming standardized, momentum is growing into its own league. As the evidence and performance results mount, it is only a matter of time for momentum to enter the mainstream.
Ben Kizemchuk is a Portfolio Manager & Investment Advisor with Altus Securities Inc. in Toronto. He offers financial planning and investment management for high net worth Canadian investors. Ben focuses on high quality investments, the Growth and Income Portfolios, low risk investing, and reducing tax.