As subscribers are well aware, Momentum is a powerful driver of stock market returns, and one we take seriously at Stockopedia. There are two sides to the Momentum coin:
- Mean reversion: The first is a long-term mean reversion in share prices. Investors forget the power of capitalism at their peril. As management and shareholders are incentivised to turn around poor-performing businesses, while the successful face increasing competitive threats. This tends to be reflected in a reversal of share prices over periods of around three years.
- Underreaction: However, over shorter periods, 6 months to a year, winners tend to keep on winning, and losers tend to keep on losing. When a business starts on a medium-term trajectory, investors are slow to update their priors. It is common market knowledge that companies issuing “ahead” statements tend to see these repeated and that “profits warnings tend to occur in threes.”
When these effects align, they can be a powerful force, and many approaches aim to combine them, such as the Stockopedia Turnaround QM strategy. Quants are in on it, too, and research papers highlight how momentum strategies can be improved by avoiding “stale momentum”; stocks that have been rising for so long that corporate mean reversion starts to affect returns.
Last year, Ed controversially concluded that bowl-shaped graphs could be one of these combinations. The idea is that an accelerating turnaround in a stock that has been underperforming for about 3 years may see the share price return to previous highs, generating strong returns for investors who jump aboard once that turnaround is clearly in place.
However, there are a couple of common pitfalls that bowl-lovers tend to make:
- Too short a time horizon: It is tempting to draw a bowl on any short-term recovery. However, to take advantage of the underlying effects, the bowl has to start around three years ago. Drawing a bowl around a much shorter-term recovery is likely to have a much more variable effect.
- Forgetting about dilution: If a company has had to issue a lot of shares to shore up its balance sheet during a turnaround, it would be foolish to expect it to return to previous share-price highs, as this would represent a much higher market cap.
- Lack of rigour: one weakness of investing based on chart patterns is that we can sometimes fit a particular shape or line to any chart. Therefore, I introduced the mathematical…
