Do Momentum Strategies Work?

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Momentum investing aims to take advantage of price trends in the stock market. It is based on a simple premise that if the price of a share has risen over a given period of time, there is a greater than average probability it will continue to rise for some time going forward. Momentum strategies don’t require fundamental analysis of companies, competitors, and market sectors. Price movement over time is the key indicator tracked.

Are markets entirely efficient?

For momentum investing to work, markets cannot be purely efficient as some economists believe. A completely efficient market implies that all relevant information is available to investors. Therefore securities always trade at their fair value. This suggests it’s impossible to beat the market through stock selection or timing. [1]

Momentum advocates believe that markets are not completely efficient and never will be. They are influenced by irrational investor behavior, causing prices of securities to rise or fall beyond their intrinsic values. Investors have a tendency to punish losing stocks beyond what is warranted, and to “jump on the band wagon” for stocks that have recently run up in price.

Momentum techniques

Momentum strategies begin with the selection of a pool of stocks to analyze over time. These stocks may be small-cap, blue chip, precious metals, or any category that fits the investor’s goals. Prices for stocks in the selection pool are tracked over some appropriate period in order to verify trends. Trends may be determined by techniques such as price sampling at specific intervals, trend lines, or moving averages. Promising stocks are purchased and held for some fixed period or until indicators dictate they should be sold.

Momentum’s worthy competitor

Momentum strategies employ a form of technical analysis in the determination of promising investment opportunities. The main alternative to technical analysis is value investing. The value approach attempts to identity securities that are undervalued in price. This may be based on company earnings and other fundamental indicators. The value investor buys these bargain stocks and waits for the market to eventually appreciate their value and drive up the price.

Momentum strategies have been characterized and being short time, while value approaches have been considered long term. That’s not necessarily true. With either approach, an investor may choose to stay in the market for a long time or a brief time. But value investing, by its nature, will likely require longer rebalance periods. The investor must wait for the market to come around to what they believe is the true worth of the security. Value investing works. Just look to Warren Buffett.

Does momentum really work?

Momentum investing seems counter intuitive. We’ve been educated to believe brilliant insights and careful fundamental analysis are critical to finding securities with potential. Evaluating stocks based on nothing more that price movement seems too simple. But does it work?

Momentum techniques have been studied in academic literature for more than 20 years. In 1993, Jegadeesh and Titman found that between 1965 and 1989, “strategies which buy stocks that have performed well in the past and sell stocks that have performed poorly in the past generate significant positive returns over 3- to 12-month holding periods.” [2] The authors followed this up with a 2001 paper that confirmed the trend through the 1990s. The research suggests that momentum profits are due to delayed overreactions to market information. [3]

In a 2001 study, Chan, Jegadeesh, and Lakonishok found, “…a stock's prior six-month return and the most recent earnings surprise help to predict future returns. The drift in future returns is economically meaningful and lasts for at least six months.” [4]

Does it work in different regions?

The momentum effect is not restricted to North American markets. A study published by the School of Economics and Finance, Queensland University of Technology stated, “…we find a strong momentum effect in Australian equities and also that trading volume plays an important role in providing information about stocks.” [5]

In a more recent paper by Asness, Frazzini, Israel and Moskowitz, the authors state,

“The existence of momentum is a well-established empirical fact. The return premium is evident in 212 years (yes, this is not a typo, two hundred and twelve years of data from 1801 to 2012) of U.S. equity data, dating back to the Victorian age in U.K equity data, in over 20 years of out-of-sample evidence from its original discovery, in 40 other countries, and in more than a dozen other asset classes. Some of this evidence predates academic research in financial economics, suggesting that the momentum premium has been a part of markets since their very existence, well before researchers studied them as a science.” [6]

The excellent paper goes on to debunk ten myths surrounding momentum investing. For example, that it only works with small-cap stocks or that it doesn’t survive trading costs. It’s well worth reading.

The above is just a small sampling of the many studies which confirm momentum techniques work. Past data can predict future results. If you’re not inclined to slog through academic papers, then watch this brief video from the London-based Financial Times. It may be light on detail, but the British accent makes it sound very authoritative.  :)

 
Jon Dearden
 

[1] Efficient-market hypothesis. Wikipedia. Retrieved from https://en.wikipedia.org/wiki/Efficient-market_hypothesis

[2] Jegadeesh, N., & Titman, S. (1993). Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency. The Journal of Finance, 48(1), 65-91. Retrieved from http://www.jstor.org/stable/2328882

[3] Jegadeesh, N., & Titman, S. (2001). Profitability of Momentum Strategies: An Evaluation of Alternative Explanations. The Journal of Finance, 56(2), 699-720. Retrieved from http://www.jstor.org/stable/222579

[4] Louis K. C. Chan, Jegadeesh, N., & Lakonishok, J. (1996). Momentum Strategies. The Journal of Finance, 51(5), 1681-1713. Retrieved from http://www.jstor.org/stable/2329534

[5] Drew, M., Veeraraghavan, M., & Ye, M. (2004, January). Do Momentum Strategies Work? Australian Evidence. Discussion Papers in Economics, Finance and International Competitiveness. School of Economics and Finance, Queensland University of Technology. Retrieved from https://core.ac.uk/download/pdf/6524184.pdf

[6] Asness, C., Frazzini , A., Israel, R., & Moskowitz, T. (2014). Fact, Fiction and Momentum Investing. Journal of Portfolio Management. Retrieved from http://ssrn.com/abstract=2435323

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