Is the trend really your friend? It seem so ridiculous that just because a price is going up that it should continue to go up, but that's precisely what has been observed in the price behaviour of stocks. Just as with jewellery, it seems that the more expensive stocks get, the more buyers start to crave them. The 'momentum' effect has been tested in many different ways by financiers, whether in theory by academics in finance journals or in practice by hedge funds, and has been found time and again to be a persistently profitable strategy. In fact it is so persistently profitable that it is now known as the 'premier anomaly' amongst finance geeks. Its acceptance makes it something of a self-fulfilling prophecy meaning investors have to beware when their stocks are trending badly.
Given that the market has been trending up over the last month, its a good time to look at what momentum indiators really work and how much can you profit from them. We have gathered our pick of the top five indicators investors should track to find momentum stocks and time the overall market.
1. 52 Week Highs and variations
Research has found that buying stocks making new 52 week highs and shorting those that aren't returned 0.6% per month over a six month holding period. Even stronger results have been found for a 3 month holding period.
The famous Turtle Trading experiment ran trend-following rules based on buying breakouts in various asset classes over much shorter timeframes - either 20 day or 55 day highs - showing that other similar strategies can work too. The full rules can be found here and the full turtle story is fascinating for historians!
2. 1y and 6m Relative Strength
Relative Strength shows the difference in the price movement of a stock compared to the price movement market over a time period. In contrast to absolute price movements, relative strength can be positive even if the stock has fallen as long as the market has fallen even further. This subtle difference to absolute strength makes it a much more useful tool for discovering all weather outperformance and thus it is more often used as a criteria in investing systems.
In What Works on Wall Street James O'Shaugnessy showed that investing in stocks with the highest 6 month relative strength from 1926-2009 would have outperformed the market by 3.65% per year! 1 year Relative Strength has been found to be extremely persistent too although very short time periods such as 1 month have been shown to be inversely correlated with return.
3. The 50 day and 200 day Moving Averages
There are hundreds of hedge funds that use momentum or trend following strategies, and one of the simplest strategies is based on the humble moving average. A moving average is the average share price over a certain number of days and when plotted on a chart next to the share price it irons out the volatility of day to day and week to week movements to show the general direction of the price. Many hardened investors won't touch a stock unless the share price is above a rising 200 day moving average line which is seen as something of a failsafe for positive momentum.
Momentum investors often take trading cues from the crossing of two moving averages. e.g. when a 50d MA crosses above the slower moving 200d MA it is a cue to go long, and short when it crosses below. A system like this would always be in the market, so some have developed the triple moving average system to act as a filter. The trader only makes long trades when both MAs are above an even longer dated 350d MA. In The Way of the Turtle back testing showed that a simple dual MA system beat a triple MA system with a compound annual growth rate of 57.8% over multiple asset classes over a 10 year period from 1996 to 2006.
The following 2 indicators are more specifically for judging the state of the overall market…
4. The Coppock Indicator
The Coppock is a long term momentum indicator that is used to spot the start of new bull markets. Coppock believed that market downturns led to a period of bereavement in investors and so asked a priest how long mourning usually took. The answer was 11 to 14 months, so he devised an indicator based on the sum of 14 month and 11 month rates of change of the S&P 500 smoothed by a 10 period moving average.
The indicator has a highly impressive history with only 4 false signals and an 83% success rate. It picked the bottom in 2009 but has more recently flagged a double sell 'killer wave' - which has historically led to 40% down moves in stocks! Coppock himself though didn't rate the sell signals as highly as the buys.
5. 9:1 Volume Days
In Winning on Wall Street Martin Zweig introduced the idea that days of 9:1 up to down volume in the market were extremely bullish - "if the tape can't ignite, conditions ain't right!". A second 9:1 volume day in quick succession created even better conditions and each time that has happened since the 1970s equities have rallied 21.59% on average over 12 months. A recent signal in April 2009 presaged a massive 25% move in the S&P 500 over 12 months.
Cursory note to Tea Leaf reading…
Many traders like to track more advanced short term statistical price oscillators claiming that they are 'leading' indicators of momentum rather than slower trend following indicators which they claim are 'lagging'. Use of such indicators as Stochastics, Parabolic SARs, and RSI may be useful as part of a sensible set of investing rules, but used on their own can lead to over trading and a huge number of false signals. If you like to use these indicators on their own you'll probably go bust to the quantitative algorithms who eat trades like these for lunch.
Warning! Savage Drawdowns and Crushing Bear Market Lows
The big elephant in the room is the fact that pure momentum strategies can be very volatile and bring big equity drawdowns to their owners. The maximum drawdown in the above mentioned back tests were between 30 and 45% for all the strategies even when the strictest limits on volatility adjusted position sizing were used.
In fact it was shown in a recent study that while momentum works persistently in normal environments in extreme markets like 2009 these strategies can crash. So beware of using momentum during bear market lows - its better to 'dash to trash'!
If you do choose to use Momentum as a key part of your stock picking strategy, be sure to ally it with sound fundamental reasons for picking your stocks to maximise the chance of persistent returns. Strategists such as Josef Lakonishok have shown that allying a momentum flavour to a pure value strategy (e.g. low PE or low PB) can significantly enhance returns.
We have been building as many of these tools as possible into our upcoming Stockopedia Premium application (you can sign up now for early beta access!). If you feel we've missed something, let us know in the comments below… what is your favourite momentum indicator?