Four weeks of sliding markets have proved to be a test of wits for momentum investors. With the FTSE All-Share down by 5.5% over the past month, some stocks that once looked promising candidates for future gains have had the brakes firmly applied to their prices. But while a number of shares have fallen in line with the market correction, a handful of others have marched on regardless. Often, these are the companies that the smart money has the most confidence in; where the earnings outlook is improving and the macro picture matters far less. When markets rebound, they can also be the stocks that are best positioned to continue to outperform. So how do you find them? 

Price momentum soars 

Buying shares that have a recent track record of rising in price (and selling those that have recently fallen) has been proven to be a potent investing strategy. A quick look at a pure price momentum formula – such as our Professor Jegadeesh - inspired Price Momentum Screen – shows that trading on relative price strength would have netted a 39.9% return over the past 12 months, against an albeit impressive 16.3% from the FTSE 100. 

Investor optimism and rising market prices have been kind to momentum stocks for much of 2013, particularly those with good news and strong financial performances. Even in the last troubled month for UK stocks this pure price momentum strategy has continued to rise: up 1.5% versus a -4.7% fall for the FTSE. But there is a need for caution. In early 2012, Andrew Lapthorne at Societe Generale warned that “if it is macro and market events and not company fundamentals driving stock prices, then using price momentum as a trading signal becomes fraught with danger”. Lapthorne was alluding to the risk that that blindly following momentum stocks can leave investors exposed to a March 2009-type crash – a rare occasion when momentum strategies are turned on their head. 

To avoid crashes, researchers have long studied so-called stock specific factors that drive price momentum to find shares that are rising on their own merit and I’ve been shouting about the performance of our Earnings Upgrade Momentum screen so far this year for precisely the same reason. Shares that have recently been upgraded by brokers (sometimes because of earnings surprises) often witness a lag in price accretion as…

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