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…
