The Big Mo: Buy Just Before Momentum Players Cause Prices To Surge

by: Steven Jon Kaplan

Have you overheard people saying to each other, "What's the latest hot tip on the market?" There are entire groups of institutional traders who utilize this philosophy, known as momentum players. They couldn't care less what they're trading--as long as it's going up. The way to make money is to anticipate how they're going to behave before they take action, and to thereby make much greater profits than they will.

One important characteristic of the financial markets has arisen in conjunction with the rapid increase in the use of computer software by institutions. Especially during the 21st century, a much higher percentage of the total trading on any given day has been done either directly through computer-generated trading instructions, or indirectly where computers generate recommendations for fund managers and other institutional traders, who then decide manually whether or not to follow these software-recommended selections. Many of these software programs are indifferent to fundamentals, or the global economic situation, or geopolitical considerations. Instead, they are entirely chart-driven, written to capitalize on perceived trends. Momentum players will buy anything that has recently been rallying strongly, in anticipation of a continued uptrend. Some of them will also sell short anything that has been plummeting, in the expectation that it will continue to decline, although this represents a smaller number of momentum players since many retirement accounts and other institutional funds are not permitted to sell short by federal law or have strict restrictions on doing so. This article highlights the primary philosophy of momentum players. Fundamentals are irrelevant to them; they emphasize technical action above all else.

I am not recommending that you should become a momentum player--far from it. The idea is to invest in such a way that your gains will be substantially increased because of the presence of such traders. In other words, the secret to success is to anticipate what momentum players are likely to start buying aggressively, and when they are going to do so.

Most of the computer software used by momentum players will generate a buy signal for any liquid asset that has recently climbed by a certain percentage. This percentage varies from situation to situation and from one software program to another, but it tends to average about 20%-30%. What this means is that if a given asset has recently climbed about 20%, some momentum players will trigger an automatic buy signal. If the institution doing the momentum buying is relatively large, the action alone could push it up perhaps another one half or one percent, which could then trigger momentum players who will buy after an increase of 21%, which will add additional upward pressure, which will then cause its price to be up by 22%, which will then trigger momentum players' automated buying, which uses the 22% level, and so on. Thus, the combined action of momentum players will often help to accelerate any uptrend that is already in place. The question is then to identify assets which are capable of climbing by 20% from a recent low point. Many momentum players won't participate in relatively obscure "pink sheet" stocks or anything which is perceived as being relatively illiquid. Therefore, an ideal choice for this purpose is exchange-traded funds, which have consistently narrow bid-ask spreads. This also avoids the unpredictability of owning individual shares, which are more likely to be subject to company-specific risks and will be less reliable than exchange-traded funds.

If we look at the universe of exchange-traded funds, which ones are most likely to gain 20% from their respective lows? The following criteria make for ideal choices: 1) those which have fallen the most in percentage terms from relatively recent highs; 2) those which are historically at least twice as volatile as the S&P 500 Index, thereby enabling them to rally powerfully in an uptrend; 3) those which can gain large percentages without having to set new all-time peaks, demonstrating their undervaluation; and 4) those which have a proven track record of periodically climbing by large percentages from their lows to their subsequent highs.

Which exchange-traded funds meet all of the above criteria? Surprisingly, although there are more than 1400 exchange-traded funds, the vast majority of them fail one or more of the above requirements. Many of these funds aren't liquid, or they are leveraged or structured in various ways, which cause them to erode as time passes and which therefore make them off limits to momentum players and many other institutional traders. Other funds are not sufficiently volatile, or don't have a track record of periodically surging higher. However, what disqualifies most funds at the present time is the generally elevated level of most equity sectors. Assets that are at or near all-time highs are not likely to increase by an additional 20%, and some of them may have already begun to decline.

The ripest area for momentum players are "fallen angels," which are securities that have shone brightly in the past but have recently shifted out of favor. In recent weeks, this mostly consists of the shares of commodity producers and related assets. While the Dow Jones Industrial Average, the Russell 2000, and many other benchmarks have recently achieved new all-time zeniths, the shares of commodity producers mostly slumped in late February and early March 2013, all the way back toward their lows of July 2009. Thus, almost four years of an overall bull market for equities has had little positive impact on these companies. In many cases, their profits have been increasing, thereby causing their price-earnings ratios to plummet. This makes them fundamental candidates for value investors, but what is more important is that they are close to becoming ideal momentum plays.

A prime candidate is the Market Vectors Junior Gold Miners (GDXJ). This fund had achieved an all-time peak of 42.97 on April 8, 2011. GDXJ had previously been as low as 21.18 on February 5, 2010, which when combined with its December 23, 2010 dividend of 2.929 yielded a total gain of 116.7%. Thus, it has proven that it can more than double. On March 4, 2013, GDXJ had collapsed to an intraday bottom of 14.95, and has since been recovering. Once GDXJ reaches 18, it will have gained more than 20%, and will therefore hit the radar of momentum players. Even if it reaches 30, which would be more than twice its recent bottom, it will still have a long way to climb before it approaches its previous top near 43. This is precisely the kind of security, which momentum players will be eager to chase, because they'll perceive that its recent 20% or 30% gain can be easily followed by another 20%, 30%, 40%, or greater future price increase. Other funds of precious-metals producers make reasonably good alternatives for similar reasons, including the Global X Gold Explorers (GLDX), the Market Vectors Gold Miners (GDX), the Global X Silver Miners (SIL), and the First Trust ISE Global Platinum (PLTM).

Funds of commodity producers in other subsectors have a proven record of periodically rallying strongly. During the past month, many of them have slumped toward their lows of July 2009. One example is the Market Vectors Coal Miners (KOL), which had surged from 9.43 on November 20, 2008, to 51.87 on April 4, 2011, thereby more than quintupling even if you don't count dividend payments. Since then, KOL has retreated dramatically, dropping as low as 21.78 on September 5, 2011, and recently just beginning to rebound from yet another pullback. KOL hasn't gained nearly as much in percentage terms from its recent bottom as GDXJ has done, but it has proven that it is capable of doing so. Since commodity shares overall tend to rise and fall together, the recent rebound for precious metals shares is likely to spill over into related assets such as coal mining.

There is also a historic pattern in which the final year of a multi-year equity bull market tends to be especially kind to commodity producers and other assets which benefit from rising inflationary expectations. Recent coordinated moves by central banks around the world to provide easy money and to explicitly attempt to fight deflation have led to currency wars and are also likely to favor the shares of commodity producers that have to pay relatively high salaries and other fixed costs, and which thereby benefit directly whenever the prices of raw materials have been climbing faster than the rate of wage inflation. This was certainly true at the end of the previous major bull market. From August 2007 through March-May 2008, companies related to commodity production were generally the biggest winners, with many of them more than doubling in price.

Those exchange-traded funds related to commodity production, and which had recently slumped toward their lowest points since July 2009, include all of the following: the SPDR Metals and Mining (XME), Market Vectors Rare Earth/Strategic Metals (REMX), Market Vectors Steel (SLX), First Trust ISE-Revere Natural Gas (FCG), Global X Copper Miners (COPX), and Global X Uranium (URA).

Interestingly, all of the above have received mostly negative media coverage in recent weeks. This is primarily because whenever any asset is suffering a significant decline, the media attempt to explain "why" it has been in a downtrend. Brokerages notice the falling prices and repeatedly lower their future target projections. Recently, there have been numerous downgrades for gold price targets for future years, including

The more pessimistic the projections become, the greater the number of analysts and brokers who will end up being forced to raise their targets in the future once prices have rebounded. As these upgrades inevitably occur, this will provide additional percentage gains which will encourage an increasing number of momentum players to eventually jump aboard the bandwagon. This frequently creates a snowball effect whereby a previous significant percentage decline such as 50% is followed by a complete recovery--which would mean an increase of 100% to regain its former level.

You may be thinking to yourself: if something is going to double, then why don't I just wait for it to first climb by 25%, and then buy it when momentum players have already been jumping aboard? Let's say that something is trading at 80, and will soon double from 100 to 200. It might seem that the move from 80 to 100 is less important than the surge from 100 to 200. However, if you buy something at 80 instead of 100 and it rises to 200, then your profit is 120/80 or 150% instead of 100%. Thus, by being early, you have increased your total gain by 50%. This is one reason why Warren Buffett has stated, "What the wise person does in the beginning, fools do in the end."

Momentum players are out there looking for the next big thing. Those assets that have already experienced their bull markets may have been momentum favorites in recent months, but as these have mostly completed their gains, many of those traders are looking for new kids on the block. The shares of most commodity producers have just begun to rebound from winter nadirs, which are close to their lows from July 2009. In recent years, all of these funds have proven that they can periodically double, triple, or better. Because they rely on computer software, momentum players won't buy any of the above-mentioned funds until they have already gained about 20% or more from their recent lows. So far, none of them has done so, and are therefore being almost completely ignored. By being early, you have the opportunity to purchase the funds listed above at unusually depressed prices before momentum players jump aboard the bandwagon and thereby drive prices substantially higher during the next several months.

Disclosure: I am long GDXJ, KOL, XME, REMX, SLX, FCG, GDX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I have recently sold the shares of general equity funds which I had purchased in May-July 2012 and in November 2012, while buying the funds of commodity producers listed above.