Max Pacella
Investment Analyst
Equities
31 May, 2021

“Go with the flow”,
“Don’t fight the Fed”,
“The trend is your friend”.

All of these statements confirm one simple idea, that the momentum of markets is a critical factor to consider in the positioning of your portfolio. If you want the quintessence of momentum trading in one sentiment however, I would go with:

“Buy the winners, sell the losers”

Momentum is often criticised for its apparent nature to react to short-term market volatility rather than fundamental views, however investors have still found success in most market conditions by utilising the primary direction of the market at any given moment.

Following on from the existing insights into growth and value factors, today we will assess the characteristics and merits of momentum, and how todays market positioning may lend itself to a successful momentum investment strategy in the near-term.

How to Go With The Flow

Momentum investing at its core is very simple; buy a stock that has been rising over a period of time, sell them when they stop rising.

The exact parameters of how you trade may change, but the general concept is to ride the upward trajectory of a company until it falls out of favour with the market.

The principle that drives momentum investing is that of ‘continuation’ – essentially the idea that markets will generally accept previous trends and move in the same direction. This tends to violate the ‘efficient market hypothesis’ (EMH), but let me put a clarifying statement:

In the long run, markets are (mostly) efficient. In the short run, markets are (mostly) heavily inefficient.

Why is this relevant? Because momentum investing is all about exploiting short term market inefficiencies. You want to catch an uptrend and exit before the market reverts to its mean – this is most frequently seen over monthly timeframes than years or decades but can still be found in an extreme bull run over a year or two.

The investor’s key skills in this strategy are to identify the starts of uptrends and know when they have run out of steam.

Source: Market Realist, Nasdaq

In the diagram above, each up arrow along the line represents an opportunity where a momentum trader may look to go long but would generally look to sell at each downwards arrow.

This applies to long-term trends (for example, buying the correction in a long-term bull market) as well as short-term market shocks: if you had just been long “equities” in general at almost anytime in the last year, this would have been a good momentum trade.

Source: Bloomberg

For this type of investing, volatility is your friend– particularly over the short-term – as it creates market opportunities to catch quick pushes up and exit once the market begins to lag.

Timeframe is also another important aspect to consider, and very often what separates a valid momentum trade from an inappropriate strategy.

Momentum is not a buy-and-hold way of making money – generally a momentum trader will not look to catch a multi-year bull run, but trade in and out over several months in order to maximise returns.

What timeframe you look at exiting momentum, and how long you are willing to hold the position until exit is paramount to a successful trade.

This has all been kept quite high-level but the same logic applies to individual stock selection; although fundamentals do play an important part of risk-management and measuring potential upside (mostly through price-to-book and price-to-earnings ratios), it is the overall trend and market movement that drives this strategy more so than owning a quality business for the long term.

Has momentum moved the needle?

In a word, yes.

Despite upsetting some EMH purists, momentum trading has centuries of empirical evidence demonstrating that the strategy works and that the market does exhibit momentum on an index and individual stock level over the short term.

In a paper titled ‘Fact, Fiction and Momentum Investing’ by the Journal of Portfolio Management, researchers make the point that despite a lack of economic theory, the phenomenon of securities that have performed well, continuing to perform well (and vice versa) is well demonstrated in different time periods and geographies.

In fact, over 212 years from 1801 to 2012, there is a well-established return premium for momentum investing in U.S equity data.

The premium? Circa 10% higher than the overall equity market annualised.

A particular point that I found interesting was that momentum tends to have a higher Sharpe ratio than a strategy like value, and this has also been demonstrated over that two centuries of data.

How and when can we utilise momentum?

Coming back to volatility for a moment, the movement of markets can create havoc for the invested and delight for those looking for buying opportunities.

Although momentum has historically outperformed roughly eight out of every ten years, it tends to have sharp drawdowns which some investors cannot bear.

This does come down to your ability to time the uptrend and plan your exit, but if you are picking a stock which has done well relative to its peers, chances are its moves both up and down will be equally impressive.

Why it is important to know that some investors cannot bear the drawdown, is that momentum is often a strategy that plays off the behavioural dynamics of the market.

If there is a short-term pullback in an otherwise strong bull run, then this is an opportunity to catch the next short-term uptrend.

Consider that a large portion of market observers and participants are expecting a pullback in equity markets in the short-to-medium term; your timing must be precise and not just buying a 5% dip in what becomes a 50% retracement, but in the event you can time it, a retracement in global equities in the future may present compelling opportunities for a momentum investor.

The views expressed in this article are the views of the stated author as at the date published and are subject to change based on markets and other conditions. Past performance is not a reliable indicator of future performance. Mason Stevens is only providing general advice in providing this information. You should consider this information, along with all your other investments and strategies when assessing the appropriateness of the information to your individual circumstances. Mason Stevens and its associates and their respective directors and other staff each declare that they may hold interests in securities and/or earn fees or other benefits from transactions arising as a result of information contained in this article.