What is a momentum crash and why does it happen ?

Tuesday, Oct 30 2012 by
9
What is a momentum crash and why does it happen

It's quite a daft premise really but, in general, constructing a portfolio full of stocks that have risen the most over the previous year or so gives you the highest probability of making a profit in the coming months. Between the end of WWII and 2008 a strategy that went long recent winners and short recent losers (i.e. top and bottom 10% of stocks ranked by 1 year price performance) returned an annualised 16.5% with remarkably low volatility. So strong is the return to these long-short momentum strategies and so universally is it witnessed across sectors and asset classes that billions are allocated to it by fund management groups globally.

Victor Niederhoffer, the famous quantitative trader, once poetically described statistical trading strategies such as this as 'like collecting nickels and dimes in front of a steamroller'. Indeed, hidden within the smooth and strong profit line of this momentum strategy lurks a black swan with a nasty bite. It displays what is known as 'negative skewness' - every once in a blue moon profits from the strategy completely and utterly collapse, wiping out careless traders in the process.

What happens in a momentum crash

In April 2011 Kent Daniel published the research paper '*Momentum Crashes' to investigate this phenomenon. A long-short momentum portfolio is created by going long the 10% of stocks with the strongest previous 12 month performance (winners) and short the 10% of stocks with the weakest (losers). He discovered that since 1926 there have been several periods during which the profits from this 'winner minus loser' strategy dramatically crashed, most notably March to December 2009 and the period from 1932 through to the end of World War II.

In normal times the winner portfolio outperforms the loser, but during such a momentum crash the loser portfolio massively outperforms the winners. Daniel illustrated this with the fact that over the 3 months between March and May 2009 the winner portfolio rose by only 6.5% but the loser portfolio (or the stocks that had collapsed the hardest in the financial crisis) rose by 156% ! Anyone short the losers clearly had a miserable time and probably went bust in the process.

Essentially, what is happening in a momentum crash is that the worst performing stocks in the market, the losers, rebound dramatically more quickly than the winners.

Thus to the extent that the strong momentum reversals we observe in the data can be characterized as a crash, they are a crash where the short side of the portfolio - the losers - are crashing up rather than down.

 Special Offer: Invest like Buffett, Slater and Greenblatt. Click here for details »

For anyone who was trading in 2009 this may come as little surprise. At the time fund managers were attempting to generate liquidity at any cost in order to pay for redemptions. In order to do so they sold bargain stocks indiscriminately. When the market turned these stocks recovered in astonishingly quick fashion.

The signs of an impending momentum crash

Clearly there are profit opportunities from spotting the signs of an impending momentum crash. The sharp eyed amongst readers will have noticed that both the momentum crashes mentioned above occurred after the nadir of terrible bear markets when volatility was at excruciating highs and when the three year market return had turned significantly negative. Indeed these signifying factors were present during other less calamitous momentum crashes such as in 2002. But the most severe momentum losses do not happen as the market collapses but after the nadir when the overall stock market is beginning a quick recovery.

During the drawdown that precedes a momentum crash the make up of the winner portfolio becomes heavily skewed towards safe, defensive (low beta) stocks, whereas the make up of the loser portfolio becomes heavily weighted with high bankruptcy risk, highly volatile, distressed bargains. (A sure sign that the loser portfolio may be about to significantly outperform is when it's beta hits 3 or more.) The loser portfolio effectively acts like a severely out of the money put option that pays off handsomely when the market recovers.

Some lessons for long-only investors

Before anyone begins to reel in terror away from using momentum in their stock picking strategy, it's worth reminding oneself that 'momentum crashes' describe what happens in a long-short portfolio rather than the typical long-only portfolio that you or I would invest int. Most long only investors should take comfort from the fact that during a momentum crash the winner portfolio does still rise from an absolute return perspective. It just doesn't work even half as well as buying the losers. While the academics may get their knickers in a twist over momentum crashes, there's really no need for long-only investors to panic - keep using long momentum indicators (Relative Strength, Moving Averages, 52 week highs and the Relative Strength Index) as part of your stock picking process.

For the nimble though, the key takeaways from Kent Daniel's paper is that during vicious market breaks - such as we witnessed in 2009 - the best opportunities to profit come from the beaten down bargain stocks that you wouldn't even wish on your mother in law. When everyone is throwing the baby out with the bathwater, it's actually more profitable over the coming months to invest in the bathwater ! John Templeton famously quadrupled his money in 1939 by buying 100 stocks trading at less than a dollar. The best place to look for those kinds of opportunities is using our dedicated bargain stock screener to find stocks trading at less than cash or less than their liquidation value. In more normal markets these so-called Ben Graham Bargain lists can be full of 'value traps'but during terrible bear market lows they often contain stock market gold.


Filed Under: Momentum Investing,
There's value in the stock market
but do you know where to look?

Get the most concise synopsis of everything that's been proven to work in value investing. If you like your stocks cheap you've found a treasure trove distilled to under 70 pages.

  • How to find ultimate Bargain Stocks with Ben Graham
  • How to spot Turnarounds and avoid Value Traps
  • From Graham to Greenblatt via Piotroski & Lakonishok
  • How to value stocks and set a margin of safety

Soon to be retailing for an RRP of £14.99, for a limited time only,
you can get your copy free by joining our 35,000 strong mailing list.

*By signing up you'll be joining our mailing list
no junk, no spam - just great content like this example.


Disclaimer:  

As per our Terms of Use, Stockopedia is a financial news & data site, discussion forum and content aggregator. Our site should be used for educational & informational purposes only. We do not provide investment advice, recommendations or views as to whether an investment or strategy is suited to the investment needs of a specific individual. You should make your own decisions and seek independent professional advice before doing so. Remember: Shares can go down as well as up. Past performance is not a guide to future performance & investors may not get back the amount invested.


Do you like this Post?
Yes
No
9 thumbs up
0 thumbs down
Share this post with friends




8 Comments on this Article show/hide all

emptyend 30th Oct '12 1 of 8
2

On the topic of momentum stocks, I'll be interested to see what happens in Apple shares when trading resumes, in view of the pull-back from the $700+ highs and the unexpected departure yesterday of two top execs.

Apple was IMO a key momentum stock behind the recent NASDAQ performance.....the consequences of a sharp sentiment change there could be interesting....

| Link | Share
emptyend 8th Nov '12 2 of 8
1

I'll be interested to see what happens in Apple shares when trading resumes, in view of the pull-back from the $700+ highs and the unexpected departure yesterday of two top execs.

Apple was IMO a key momentum stock behind the recent NASDAQ performance.....the consequences of a sharp sentiment change there could be interesting....

....now $537 - and looking pretty weak in the near term.....

| Link | Share
loglorry 9th Nov '12 3 of 8
2

Apple like most MoMo stocks is interesting but how do you make money from them unless you got in early. If you are long then how do you know when to sell as they always look expensive but still keep climbing. If you look at them at $700 and think they are really very expensive and try to short them you may well get burned betting against the momentum. I don't think there is an easy answer here with stocks like Apple and Google etc. The herd can drive them a lot higher or lower and it is hard to invest rationally when the herd is not rational.

Log

| Link | Share | 1 reply
emptyend 9th Nov '12 4 of 8
2

In reply to loglorry, post #3

True, re the herd.

In Apple's case I certainly thought they looked too expensive at $700 (can't recall where I said that - debate with Isaac somewhere I think) ....but then I don't short anything. Ideally of course one would get in long early on - but I guess the point with all momentum stocks is that they tend to keep going longer in the same direction than their peer group does. VERY much longer in some cases. Accordingly perhaps one needs more of a private equity mindset with them?

I think there are several very good reasons for thinking Apple might get derated by the market, most of which relate to the very source of their stunning success in recent years........the basic question being can they maintain a pipeline of innovative desirable products that can be sold at a fat premium over competitors - or will their competitors make more of a fist in fighting back?  I know where I stand on that - but doubt I'll be putting a trade on.

ee

| Link | Share
tiswas 9th Nov '12 5 of 8
2

Apple: What’s the Case for Its ‘Bear Market’ Status?

http://finance.yahoo.com/blogs/the-exchange/apple-case-bear-market-status-203033820.html

| Link | Share | 1 reply
Edward Croft 9th Nov '12 6 of 8
1

In reply to tiswas, post #5

I ordered an iPhone 5 and was told it would be with me in 3 days. A week later I called to hassle them. I was then told 3 weeks. I have now just called 3 weeks later and asked where it is... I've now been told up to 12 weeks.

Seems like Apple is struggling to keep up with demand. Clearly the demand is off the scale of even their own projections.

Blog: Follow @edcroft on Twitter
| Link | Share
davjo 9th Nov '12 7 of 8
1

Seems like Apple is struggling to keep up with demand. Clearly the demand is off the scale of even their own projections.

Either that or the latest consignment aboard the MS Apple has sunk in the South China Sea ;-)

 

| Link | Share
Fangorn 10th Nov '12 8 of 8

You'd be better off getting a Samsung Galaxy S3 in my view. Far superior and distinctly better service if your mobile develops a problem. Apple stores are disgraceful, particularly if your child's phone develops a repeat problem(They try to fob you off several times, and when you put your foot down you still have to book an appointment with an in house engineer - getting a same day appointment is unheard of - and the inconvenience of having to return at a later date only to be told that your child's phone has the same "repeat problem" is infuriating)

Won't buy Apple going forward ever again.

| Link | Share

What's your view on this article? to Comment Now

 
 
You are feeling neutral

Use the £ sign in front of a ticker to turn £VOD into Vodafone PLC

You can track all @StockoChat comments via Twitter


About Edward Croft

Edward Croft

Follow

CEO at Stockopedia where I weave code, prose and investing strategies to help investors beat the stock markets. I've a background in the City and asset management but now am more interested in building great stock selection tools for the use of investors online.   Traditionally investors online have had very poor access to the best statistics, analytics and strategies for the stock market and our aim is to set that straight.  High Quality fundamental information has been prohibitively expensive in the past and often annoyingly dull. People these days don't just want to know the PE Ratio and look at a balance sheet. They expect a layer of interpretation over data, signal from noise and the ability to know at a glance whether a stock is worth investigating or not. All this is possible using great design and the insights gleaned from quantitative research.  Stockopedia is where we try to make it happen ! more »


Stock Picking Tutorial Centre



Stock Picking Simplified

Stockopedia takes your stock picking to the next level with cutting edge Stock Reports & Screening tools.


Get started
or Take a Tour to find out more.
Join us at the London Investor Show next Friday at Olympia