4/07/2010

It will be interesting to see how these momentum stocks perform in a short-term market pullback

This has been an ideal market for professional momentum chasers like me. For last several weeks the market has rewarded momentum.

Many traders are skeptical of momentum strategies and which is a good thing. That is what makes market interesting. And creates profit for momentum traders.

However studies after studies show that the only persistent anomaly in the market is momentum.


If you study the momentum anomaly and various research related to it, you will find:
  1. Jegadeesh and Titman (1993) showed that there is substantial evidence that indicates that stocks that perform the best (worst) over a three to 12 month period tend to continue to perform well (poorly) over the subsequent three to 12 months. Momentum trading strategies that exploit this phenomenon have been consistently profitable in the United States and in most developed markets.
  2. Moskowitz and Grinblatt (1999) found evidence of momentum in industry returns. They found that high momentum industries outperform low momentum industries in the next six-months.
  3. Momentum profit reverse post 2 year holding periods.
  4. Firms that are followed by fewer stock analysts exhibit greater momentum.
  5. Like price momentum, stocks with high earnings momentum outperform stocks with low earnings momentum.
  6. A momentum strategy that buys stock near their 52 week high is profitable.
  7. Momentum effect is more pronounced in small stocks.

Momentum works the key is to make it work for you. As I have said before there are many things which work in the market provided you can build a bridge between the concept and a workable method. Most beginner traders fail to do that.
To trade momentum successfully you need to develop a setup based on momentum.

30 stocks with momentum
AGM
AHT
BANR
BEE
BELM
CPE
CTEL
DCTH
ENTR
FCH
FNSR
HT
HUSA
INCY
ISSI
ITMN
JOEZ
MPG
MTG
PEI
PXLW
RDN
SLXP
SMI
SOMX
TGA
WNC
ZANE
ZIOP
ZQK

One of the questions raised yesterday was what will happen to these momentum stocks if market has a correction or pullback at this level. To understand that you have to look at stocks with momentum for a  month ago, 2 month ago, 3 month ago, and so on.

Corrections and pullbacks creates opportunities for momentum traders. During pullback some momentum stocks reverse, some form wide range, some have a very orderly and shallow pullback. When the correction gets over the last kind are the ones which breakout first.

If we understand this phenomenon well we can build lot of trading strategies around this.
Short term momentum (momentum of a month) is generally negative. Stocks with high momentum on monthly time frame will revert their momentum. Hence most professional momentum chasers look for a momentum stock with sideways move or pullback/consolidation in last 10 to 20 days before breakout. So the setup buys breakout after a weakness. Also setup exits in to strength without waiting for a pullback. Most swing trading strategies are built to exploit short term momentum. You can build both long and short strategies to exploit short term momentum. While I trade momentum primarily from long side traders there are some who do it very successfully using a short setup. For example look at Reaper Trades, he trades on short side.  The basic idea behind his setup is that short term momentum spike in penny stocks will mean revert.  There are many ways to skin the momentum cat provided you know how momentum works.

Medium term momentum (3 to 18 months) is good. Stocks with such momentum characters persist in their direction of momentum. They might have pullbacks on the way but they tend to breakout in direction of the momentum. IBD CANSLIM method is largely based on trading stocks with such medium term momentum characteristics. The IBD 100 and IBD 200 lists are primarily stocks with medium term momentum which also have growth characters like high EPS growth, high margin, high roe and so on. If you want to be position trader then you you need to build strategies around medium term momentum.

Long term momentum (momentum of 2 years plus) is not good. Typically such stocks tend to revert. Very few stocks can sustain such long momentum phases. Stocks become extremely overvalued or over owned by funds and investors and such stocks reverse. This phenomenon works in reverse also where stocks with very low long term momentum revert and go on to make big moves. Value investing and contrarian investing is based on understanding of such phenomenon. Successful long term short selling strategies are also based on this phenomenon. If you see the Virgins strategy  I have detailed it is based on such long term momentum reversal as basic idea. Same way when looking at Episodic Pivots candidates I look for stock with years of neglect with catalyst. Those are the stocks which make big moves.

If you understand how momentum works on these three time frames then you can design several strategies based on momentum. Ultimately growth and value investing strategies are subset of momentum strategies.

Understanding momentum is key to understanding the market. That is the most persistent phenomenon in market.


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2 comments:

zephyro said...

Love the blog but slightly confused by this: "However studies after studies show that the only persistent anomaly in the market is momentum."

As far as I know there are four independent factors that have outperformed in the stock market which have survived robustness checks: 1)earnings, 2)value, 3)size & 4)momentum, so I use all of these to indentify trades. Would you agree with these?

Pradeep Bonde said...

Yes. And most strategies marry the other three with momentum to amplify returns.