Momentum means the same thing in markets as it does in physics: A price in motion will stay in motion unless acted upon by some force. If a security’s price has been moving upward over a period, it will most likely continue in that direction during the next period. There seems to be some good evidence in the literature to suggest that this is a bona fide factor, much to the delight of technical analysts. The trend, it appears, is indeed your friend. The academic literature on this subject is confusing because there are two different ways of looking at the idea of momentum.
One is cross-sectional momentum: This is where we judge momentum by referencing what other stocks are doing. It is a relative measure frozen at a particular point in time. Time-series momentum looks at the performance of a particular security across time. There is good evidence that both methods identify a factor to be considered in designing a portfolio. It is especially worthy of note that momentum tends to be negatively correlated with value. This can provide some interesting possibilities from a diversification perspective.
Momentum lends itself to a stock picking strategy more than it does an indexing strategy. Momentum funds do exist, but they tend to be very costly in terms of expenses; frequent trading is required with a momentum strategy. Indexing options have been developed in the recent past, thanks to various low-cost ETFs. For example, the iShares Edge MSCI USA Momentum Factor ETF that “seeks to track the performance of an index that measures the performance of U.S. large- and mid-capitalization stocks exhibiting relatively higher momentum characteristics.”
Researchers have shown that trading based on individual stock momentum appears to be a poor strategy when using a short-term strategy, but it is highly profitable at intermediate horizons (up to 24 months) and is strongest in the six to twelve-month range. The strategy tends to fall apart for the longer term, and a buy and hold strategy cannot be merged with it. It is also worthy of note that whole industries follow the same momentum trajectory. Tobias Moskowitz and Mark Grinblatt found that industry (sector) momentum accounted for most individual stock momentum and that industry-based strategies were more profitable than individual stock strategies. They further observed that industry strategies worked better as a long-only strategy, while individual stock strategies did better selling the losers than it did buying the winners.
Since most of us cannot hold short positions in our retirement accounts, the industry momentum strategy seems to have a lot going for it. This suggests that narrative tailwinds could keep driving prices higher in a behavioral rather than risk-based model, and that narrative headwind could keep prices in decline. Many sectors have ETFs, and mutual funds that represent them and these could provide exposure to momentum for the entire sector.
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Last Updated: 6/25/2018